MFI: Money Flow Index

Construction of the money flow index

As we have seen, the MFI represents the flow of money into and out of a financial instrument in a given period of time. By adding both the negative and positive values of the monetary flows, we obtain a Money Ratio which is represented as a line of an oscillator.

This oscillator, which is placed in the lower part of the chart, has a scale from 0 to 100 given by the Money Ratio on the ordinate axis, while the abscissa axis represents time.

Two level lines on the ordinate axis with standard default values of 80 and 20 represent the levels of OVERBOOKED (80) and OVERSOLD (20), but they are variable depending on the financial instrument studied and the market situation.

Many traders move these values to 90 for overbought and to 10 for oversold to eliminate as much as possible the false breakout signals.

How the MFI works

The MFI is generally set at 14 periods with the oscillator line moving over time, marking the cash flow values concerning the financial instrument studied, highlighting when there are limit situations of OVERBOUGHT or OVERSOLD.

Oversold levels we have seen typically occur below the Money Ratio level of 20, while overbought levels typically occur above the 80 value. The level lines should cut the highest peaks and the lowest troughs generating a signal at their intersection.
During strong trends, the MFI may remain overbought or oversold for long periods and continue to retest the same areas frequently.

It is interesting to note that if the price of the financial instrument studied reaches a new high or low, but this is not confirmed by the MFI, this divergence can signal a price reversal.

It is also possible to act on the initial oscillator set-up by modifying the value of the observed periods; varying the standard value by 14 periods, allows to attenuate or accentuate the overbought and oversold signals.

By increasing the value from 14 to 20 periods for example, we will have a decrease in background noise and a series of less frequent signals.

On the other hand, by decreasing the period, for example to 5, we will see a speed of movement of the index values which, in the event of high volatility, can generate a series of overbought and oversold signals even in a few trading sessions.

The money flow index as a price target

This oscillator allows you to have entry and exit signals at the break of the overbought and oversold levels, but usually they are not sufficient to guarantee correct entries / exits. In fact, it is always advisable to combine the MFI with other indicators, such as the Bollinger Bands or the MACD to confirm the signals.

However, we must not be fooled by these signals for two simple reasons. The first is that reaching an overbought or oversold level does not mean that the price will reverse the trend in the immediate future; if supported by a significant price momentum, it will remain in the overbought or oversold area for longer.

The second is because the only real certain signal that this oscillator provides is given through the search on the graph of the divergences between price and indicator. The relevance of a divergence increases as the proximity to an extreme overbought or oversold zone increases.

In summary, the Money Flow Index provides a BUY entry signal when the breakout of the 20 value of the Money Ratio occurs, which delimits and identifies the oversold area; reaching this value indicates that the directional thrust of the downward trend is being exhausted. However, this signal is not sufficient to consider an entry valid at 100% that must be confirmed with the presence on the chart of a bullish divergence, or with the breakout of an important price resistance, or by applying a filter using a second indicator such as the WaveUP Indicator. which can confirm the signals.

For SELL signals, the breakout of the value 80 will establish the probability of exhaustion of the ascending trend by entering an overbought zone.

Also in this case it is necessary to confirm this signal with the same indications and filter and control instruments mentioned for the BUY input situation.