Stock trading is a process of continuous learning and analysing markets. Traders, therefore, need to have a clear understanding o the price and volume movements of their target stocks and the market as a whole. There are various technical analysis tools that traders can use to meet this requirement and help them in their decision-making process. The MFI Indicator is one of the many indicators often used by traders on daily basis. Given here is the meaning of MFI and related details of the same.
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What is MFI?
MFI stands for Money Flow Index which is a technical indicator. This is a measure of the momentum of money flowing into or out of a security over a specified period of time. It is an oscillator indicator that is flowed between 0 to 100. This indicator is based on two components namely the price and the volume of the security. These components are used to determine if the stock is overbought or oversold. The MFI formula considers the direction of the price movement of the security as well as the total volume of the shares that are traded in the market.
How to calculate MFI? Step by Step procedure
The Money Flow Index (MFI) is the oscillator indicator that is calculated using a combination of price and volume data and is calculated using the typical price. The formula and steps for calculating MFI are given below.
- Determine the typical price
Traders first need to calculate the typical price which is calculated by adding the high, low, and close prices of a given period, and dividing the result by 3. This will give the average price for the period.
Typical Price = (High + Low + Close) / 3
- Calculate the raw money flow
The next step is to calculate the raw money flow which is calculated by multiplying the typical price and the volume for the period.
If the typical price is rising, this indicates that money is flowing into the security, while a falling typical price indicates that money is flowing out.
Raw Money Flow = Typical Price x Volume
- Calculate the money ratio
Following this, traders need to calculate the money ratio which compares the raw money flow for up periods (when the typical price is rising) to the raw money flow for down periods (when the typical price is falling). The formula for the same is given hereunder.
Money Ratio = Positive Money Flow / Negative Money Flow
Where,
- Positive Money Flow = Sum of Raw Money Flow for Up Periods
- Negative Money Flow = Sum of Raw Money Flow for Down Periods
- Calculate the money flow index
Finally, traders need to calculate the money flow index (MFI) which is calculated by dividing the money ratio by 1 + the money ratio and then multiplying by 100.
Money Flow Index = 100 – (100 / (1 + Money Ratio))
The resulting number is the Money Flow Index for the given period. The MFI is usually calculated over a period of 14 days. However, traders can adjust the time period as per their individual needs.
How to trade with MFI?
The MFI can be used to understand market trends and trading opportunities. Traders can use the MFI to create trading opportunities in the following manner.
Identify overbought and oversold positions
The MFI is typically used to identify overbought and oversold conditions in the market.
- Security is considered to be overbought when the MFI rises above 80. It may also suggest that the security is due for a pullback.
- Security is considered to be oversold when the MFI falls below 20. It may indicate that the security is due for a rebound.
Identify divergence
Divergence occurs when the direction of the MFI is opposite to the direction of the stock’s price movement. In case the stock is making higher highs but the MFI is making lower highs, this may be a sign that the upward trend is losing momentum and that a reversal is imminent. This is known as the bearish MFI divergence. Conversely, when the MFI is making higher lows and the stock is making lower lows, it signifies that sellers are losing momentum and the buyers will soon take over. This is known as the bullish MFI divergence,
Failure swings
A failure swing occurs when the MFI makes a higher high or lower low than the previous peak or trough, but the security’s price does not follow suit. This indicates a potential reversal of the trend.
Bearish failure swing
A bearish failure swing occurs when the MFI rises above 80. This indicates the overbought position of the security and it subsequently falls below its previous low. In such a situation, if the security’s price does not make a lower low at the same time, it translates into a bearish failure swing which may indicate that the security is about to reverse and begin a downtrend.
Bullish failure swing
A bullish failure swing occurs when the MFI falls below 20. This indicates that the oversold position of the security and subsequently rises above its previous high. In such a scenario, if the security’s price does not make a higher high at the same time, it is said to be a bullish failure swing which may indicate that the security is about to reverse and begin an uptrend.
Conclusion
MFI is a very popular technical analysis indicator that is used by traders to understand the market position and to navigate price and volume fluctuations. However, it is prudent to use other technical indicators to confirm the ongoing trend of trend reversals to ensure optimum analysis of the market.
FAQs
Some advantages of using the MFI oscillator indicator are identifying overbought and oversold conditions, understanding early warning signals for trend reversals, confirming the strength of the ongoing trend, and understanding market positions in a better manner.
Few limitations of using MFI include generating false signals, not ideal for markets that are trading sideways, can be a lagging indicator, and requiring the traders to have a careful understanding of the market.
An overbought MFI which is over 80 signifies a strong sell signal
The two components used in MFI are the price of the stock and the volume that is being traded in the market
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