An Introduction to Money Flow Index

What Is Money Flow Index (MFI)?

Like an RSI indicator, the Money Flow Index (MFI) shows high and low bounds between two extreme values in an indicator shown under the chart. The indicator uses volume and price data to establish a range from which traders can make critical trading decisions. The MFI is based on the idea that the volume alone isn’t indicative of the market’s overall state. Hence, investors should also consider how the market responds to price changes. Putting price and volume data together gives a better representation of the market sentiment, and it is measured in values between 0 and 100. On a typical trading chart, the MFI is plotted as a line that oscillates between 0 and 100. A rise in the MFI curve or index represents a growing buying pressure, while a drop in the curve or index value indicates increased selling pressure. The Money Flow Index represents the inflow and outflow of money into an asset over a period of time. When the MFI shows a buying pressure, it indicates a positive money flow, while a selling pressure indicates a negative money flow. The positive and negative money flows give the money flow ratio used in the computation of the MFI. These values are important in understanding how to trade DeFi assets even though it originates from traditional stocks and commodities trading.

DeFi traders, stock traders, financial analysts, and quantitative analysts use the Money Flow Index. When prices move in the opposite direction of an indicator, a divergence is established. The MFI is one of the best indicators of this trend that often marks market reversals. If the MFI is falling below 80 points and the price of an asset such as Bitcoin keeps rising, it could hint at a possible reversal of the price to a downside. If the MFI is pulling back from the low of 20 while the asset's price keeps falling, it could be a sign of a potential reversal, marking the beginning of an increase in the price of the asset. Another point where the MFI is used is when successive highs are suddenly broken to establish a new high. If the price of Ethereum starts at a high of $4,000 before moving down to $2,500 and then back to $3,950, a move to a new high of $3,900 shows a rejection of the uptrend and an imminent downtrend in the asset price.

The Money Flow Index shows the dominant market sentiment at a given period. It provides insights on how much of the asset under consideration is traded and how it is being traded. With the MFI, traders can conveniently understand market buy and sell pressures as quick and straightforward numbers. It is used to help traders spot upcoming changes in the market trend, which helps them to plan better moves to protect their portfolios. It is a tool for timing the market and spotting reversals, failures, swings, divergence, etc. An increasing selling pressure, for example, can inform a trader to short the asset to prevent losses. The opposite goes for a rising buying pressure which indicates a potential uptrend.

Similarities between MFI and RSI

• Both the MFI and the RSI are bounded indicators oscillating between numerical values of 0 and 100.
• The RSI and the MFI can be used to spot positive and negative divergence, which helps traders assess the momentum of an asset.
• Calculations of the RSI and MFI both consider the momentum of the asset under consideration.
• The RSI and MFI are both momentum oscillators marking high and low bounds in two extreme values.
• The RSI and MFI are not the best indicators to determine entry but can serve as excellent tools for trend confirmation.

Differences between MFI and RSI

• While the RSI has oversold and overbought readings at 30 and 70, the MFI has oversold and overbought readings at 20 and 80 or 10 and 90.
• Calculations of MFI differ from RSI in the addition of volume, which is weighed when calculating MFI.
• The RSI and MFI differ in how they react to changes in the momentum of an asset. The MFI is a more consistent representation of divergence.
• In real trading situations, the MFI may be more reliable in pullback confirmation than the RSI. If the 200 period moving average, for example, is below the price, and the MFI is moving out of the 20-point range, a pullback marks a strong buy confirmation.

How to Calculate Money Flow Index

Instead of blindly following the indicators, traders need to understand where the Money Flow Index is coming from. Mathematically, the MFI is given by:

Money Flow Index = 100 - 100/1+ Money Flow Ratio

The Money Flow Ratio measures the positive and negative money flow over the period under consideration, and it is represented mathematically by:

Money Flow Ratio = 14 days positive money flow/14 days negative money flow

The Raw Money Flow shows the value and how much the price in the period under consideration goes into the volume for the period under consideration. You can think about it as the actual money flow, and it is represented mathematically by:

Raw Money Flow = Typical Price x Volume

Where the Typical Price = High + Low + Close/3

These calculations give us an index of 0 to 100, representing the MFI for the asset under consideration. It is less likely that you will ever have to compute the index by hand due to automation. However, we can break down the step-by-step calculation process if you are still curious or passionate about the number-crunching process.

1. Find the Typical Price for the positive and negative 14-period money flows using the Typical Price formula given before.
2. A higher Typical Price than the previous period indicates a positive money flow, while a lower Typical Price than the previous period indicates a negative money flow.
3. Now multiply the Typical Price by the volume to get the Raw Money Flows for each period without changing the positive or negative numbers.
4. Now add up the positive and negative money flows separately.
5. Divide the positive money flows by the negative money flows to get the Money Flow Ratio.
6. Use the initial MFI formula, 100 - 100/1+ Money Flow Ratio to calculate the MFI for each period.
7. Repeat the process starting from the previous period data at the end of the last period.

Limitations of the Money Flow Index

It is not advisable to rely on the MFI alone, especially for entry signals, because these indicators have many fake signals. If you place your bet on a positive MFI without confirming with stronger indicators like moving averages or exponential moving averages, you may lose your trade. The reason for this is the typical divergence situation when the price is moving in an opposite direction from the indicators on the chart. The MFI may not also be a great indicator for predicting sudden pullbacks and reversals, even though it might measure the same. It is often possible the events in the market are already playing out against you by the time you have it reflected by a positive or negative MFI. Nevertheless, it can help you act quickly to prevent further losses or adjust your stop loss for further gains. However, the MFI remains useful for confirmation of decisions and should be adequately tested with any given strategy to ascertain its effectiveness.