Keeping track of a stock or commodities market price on a routine basis is a time-intensive task. In the course of everyday trading, you may need to analyse the price movement for more than a hundred distinct entities across various industries around the world. Economists have devised several tools for day-to-day usage to simplify this task for you.
What is the Money Flow Index?
The Money Flow Index (MFI) is an oscillator that produces a number between 0 and 100 for a certain stock. If the reading goes above 80, the stock is considered overbought. If it is below 20, the stock is considered oversold.
Take a look at how the money flow index is calculated to understand how you can put it to work.
How to Calculate the Money Flow Index?
Money flow index calculation begins with measuring the Typical Price of a stock. You can get the Typical Price by taking the average of the High, Low, and Closing Prices for a certain stock.
Typical Price = (High + Low + Close) / 3
Now, multiply the Typical Price by the Trading Volume in the period to arrive at the Raw Money Flow.
Raw Money Flow = Typical Price x Volume.
Add the money flows together for the days when the Typical Price is greater than the previous day. This gives the Positive Money Flow.
Similarly, add the money flows together for the days when Typical Price is lower than that on the previous day. This gives the Negative Money Flow.
The ratio between the Positive Money Flows and Negative Money Flows gives the Money Ratio.
Money Flow Ratio = Positive Money Flow / Negative Money Flow.
Now, you can use the following formula to arrive at the money flow index:
Money Flow Index = 100 - [100 / (1 + Money Flow Ratio)].
Typically, the money flow index tracks data from the preceding 14-day period.
Advantages of Calculating the Money Flow Index
Calculating or keeping track of the money flow index can benefit you in several ways:
1. Overbought & Oversold Identification
The price of any stock in the market is vulnerable to the forces of "pressure" and "inertia". A rising price may encourage more traders in the market to buy, which in turn causes the price to rise even more. However, as the price rises to an unsustainable level, the market slowly corrects course and smoothly arrives at a correct representation.
The MFI indicator can help you understand these pressures early. If the money flow index value rises above 80, the stock may be overbought and soon lower to a regular level. Similarly, if the money flow index value is lower than 20, the price of a stock is at a considerably low level and may be due for a rise.
You can use this data to identify extreme shifts in prices early and act on this information before the situation gets out of hand.
2. Divergence Indication
The MFI indicator can sometimes move opposite to the stock price. These diversions can be of two types:
A very low money flow index reading climbs to above 20 while the stock continues to sell off, indicating a decrease in selling pressure. Buyers may soon rush the market. It also presents you with a unique opportunity to buy securities at attractive prices.
A very high money flow index reading begins to fall below 80 while the stock price continues to rise, indicating an increase in buying pressure. The market may soon host a lot of sellers. Being an early mover who can anticipate demand, you can receive more attractive prices for your stocks.
3. Failure Swing Detection
A failure swing is an advanced diversion that indicates price reversal. Here's what usually happens:
The price goes to a lower low, but the money flow index rises above the previous high, triggering a buy signal.
The price goes to a higher high, but the money flow index falls below the previous low, triggering a sell signal.
Some traders also use the MFI indicator to locate larger divergences using the MFI & price data over a large period.
For example, let's say a stock you have been tracking peaks to a price of ₹500, falls to ₹480 and then rallies to ₹492. So, the stock has seen two successive highs of ₹500 and ₹492.
If the money flow index makes a lower high when the price reaches ₹492, it does not confirm the new high. This could foreshadow a coming decline in price.
Limitations of the Money Flow Index
There are a lot of factors that move a stock's price apart from the things that market data can predict. A sudden shortage of semiconductors or a natural disaster impacts a company's facilities. Such factors impact the market as the underlying securities. So, the market divergence data based on the previous two weeks may not be accurate for making predictions for the next two weeks.
As explained above, the MFI indicator can help you demystify certain movements of the market. However, please keep in mind that no indicator should be used in isolation to make decisions about your hard-earned money.
This is why we at AngelOne encourage you to learn more about investing and the different types of market indicators. Access our vast database of knowledge created and curated by experts and become a smart investor.