The Money Flow Index (MFI) refers to a popular technical oscillator that gauges the inflow and outflow of capital into an asset over a period of time. The MFI tracks the price and volume to evaluate the buying and selling forces in the market.
How Does The Money Flow Index (MFI) Works?
The index’s value is reflected on a scale between 0 and 100. The resulting number of the MFI calculation will be a number in this range used by traders to identify overbought and oversold Forex signals. As a general rule, if the calculated MFI is higher than 80, the market is overbought and if it’s below 20 it indicates oversold market conditions.
The main purpose of using the MFI is that when the market hit these levels, it could indicate price reversal and traders should enter the market to try and capitalize on the momentum. Keep in mind that sometimes the price of an asset and the MFI may provide opposite signals. That is called divergence.
For instance, if the price of an asset is reaching new highs but that’s not reflected in the MFI, that’s a sign of a bearish divergence which means that you can expect additional selling pressure. Conversely, if the price drops to new lows but the MFI doesn’t reflect that movement, it could be a sign of bullish divergence and incoming buying pressure.
However, it’s important to know that divergence isn’t always followed by a price reversal. This means that the money flow index can also generate fake signals which emerge when the indicator produces a solid trading opportunity but the market price doesn’t move in the anticipated direction.
Calculating The Money Flow Index (MFI)
Forex traders never have to manually calculate the money flow index since the online trading platforms do this for them. However, knowing how to do it might be of great help since it will help you understand what is this indicator actually telling you.
First of all, you need to calculate the typical price. This is done by computing the average price of the high, low and closing price.
After that, find the raw money flow by taking the typical price and multiplying it by the volume for that period.
Next, you need to find out whether the calculated raw money flow for that period is positive or negative. When the typical price for the period is higher than it was in the previous period, the money flow is positive and the other way around.
Once you’ve determined positive and negative money flows, you need to calculate the money flow ratio by taking all the positive money flows over the last 14 periods and dividing this figure by the sum of the negative flows over the last 14 periods.
Finally, once you have the money flow ratio you can calculate the Money Flow Index. See the formula below:
The MFI value is positive if the price of the underlying asset has prevalently increased over those 14 periods and negative if it has predominately depreciated during that period.
In conclusion, the money flow index (MFI) is a momentum indicator that gauges the inflow and outflow of money into an asset over a period of time. The calculation of the MFI is usually based on 14 periods of price data.
Its value is reflected on a scale between 0 and 100, with 20 and below indicating oversold market conditions and readings above 80 indicating overbought conditions. If the market hits these levels, a price reversal could be expected.
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