A Money Flow Index (MFI) is a type of oscillator in the technical market that utilizes volume and price information to detect overbought and oversold indicators in an asset. It is also utilized to identify divergences that indicate an upwards or downwards price. The oscillator fluctuates between zero and 100. In contrast to conventional oscillators like the Relative Strength Index (RSI), a standard oscillator, the Money Flow Index incorporates both volume and price data in addition to the price. In this way, some analysts consider MFI an index that is a volume-weighted RSI.
What Does the Money Flow Index Tell You?
One of the main methods to utilize an index like the Money Flow Index is when there is an occurrence of divergence. A divergence happens when the oscillator moves in the opposing direction to the price. This indicates a possible reversal within the current price trend. For instance, an excessive Money Flow Index that begins to drop below an 80 reading as the underlying security continues to rise indicates price reversal towards the negative. A very small MFI reading that rises over 20 and the underlying security continues to be sold off is a reverse signal for the upside.
Investors are also looking for greater divergences by observing multiple waves in value. For instance, a stock peaks at $10; it is lowered to $8, then rises to $12. It has hit two consecutive highs at both $11 and $21. If MFI creates a lower high at $12, the indicator does not validate the new record. This could signal a possible decline in value. The levels of overbought and undersold are also used to identify the possibility of trading opportunities. Moving below ten and over 90 is extremely rare. Traders are watching for the MFI to rise above 10 to signal an extended trade and then to fall below 90, which signals the possibility of a short trade.
Other movements out of the overbought and oversold area can also be helpful. For instance, if an asset is trending up and falls to below the 20 (or even 30) followed by a rebound up to it, it can indicate that a pullback has ended and the trend is beginning to resume. Similar to a downtrend. A rally in the short term could propel the MFI upwards to 70 or 80. However, when it drops below that, it could be the right time to open an option to trade short in preparation for a decline.
Money Flow Index Signals
Overbought/Oversold Condition
A security is considered overbought if its MFI displays a rapid price rise to a significant amount. In the same way, security can be classified as oversold when the MFI displays a rapid decrease in price to a significantly low level. The levels of overbought and oversold can be useful in determining the presence of extreme prices. Generally, conditions of overbought occur when the MFI is greater than 80, and less than 20 MFI is a sign of oversold conditions. The prices could remain on the rise as long as the trend upwards is robust and the MFI may rise above 80.
However, MFI can drop below 20 if the prices fall further due to an accelerating downward trend. If MFI rises above 90, it's considered an overbought situation, while a lower MFI is considered an oversold situation. However, MFI over 90 and less than 10 occurs rarely and indicates that price movements are not durable. A lot of securities trade on the exchange market but do not reach the price extremes at the 90/10 mark.
Divergences
Divergence signals are when the signals of the price movement and MFI are in opposition. The divergence in the indicators could be thought to be an indication of an imminent change in direction. Particularly there are two kinds of divergences:
Bullish Money Flow Index Divergence
It happens when the price reaches an all-time low. In contrast, the MFI shows a high low, indicating an increase in cash flow. This means that sales pressure has decreased, and buyers will take control of the market. This opens the possibility of buying securities at bargain prices.
Bearish MFI Divergence
It happens when the price reaches new levels, and the MFI shows a lower low. It indicates a decrease in pressure to buy and an opportunity for sellers to dominate the market. This is a chance for sellers to earn profits.
