How to use the money flow index to analyze markets

Also known as the volume-weighted RSI, the money flow index is an oscillator that helps gauge the strength and direction of money flowing in and out of a security over a period of time. In this article, we cover what the money flow index is, how to calculate it, its advantages over other indicators like the relative strength index (RSI) and how to effectively use it in trading strategies.

What is the money flow index?

The money flow index (MFI) is a volume-weighted oscillator that helps gauge overbought and oversold markets. The indicator looks at both the price level and volume of trades moving in and out of a security. It can help you gain an idea of how many people are going long or short on the market.

Like other oscillators, the money flow index is set on a scale of zero to 100. If the MFI moves too close to zero, an oversold market is indicated. Conversely, a high MFI suggests the market may be becoming overbought. The money flow index is most often used to detect impending reversals or divergences between price action and trading volume.

How to calculate money flow index

The money flow index calculates the ratio of positive and negative money flow over a period of time. The formula for calculating the money flow index involves several steps. Most platforms like FOREX.com will calculate the MFI automatically, but it can be useful to understand how it’s done.

1. Determine the typical price by adding together the high, low, and closing prices of a security and dividing the sum by three
2. Calculate the raw money flow by multiplying the typical price by the volume traded during a given period. The default version uses a 14-period MFI
3. Compare the current typical price with the previous typical price to classify the money flow as positive or negative. If the current typical price is higher, it is considered positive; if it is lower, it is considered negative
4. Calculate the money flow ratio by dividing the sum of positive money flows by the sum of negative money flows over a specified period
5. Finally, calculate the money flow index using the formula: 100 - (100 / (1 + money flow ratio))

FOREX.com charts feature dozens of indicators that can be applied with a single button, including the money flow index. Learn more about our award-winning trading platform or open a FOREX.com demo account to practice using the MFI today.

Money flow index strategy

The money flow index can be a valuable tool in developing trading strategies. One popular approach is to identify potential reversals in market trends by looking for divergences between the price of a security and its corresponding MFI. For instance, if the price is making higher highs while the MFI is making lower highs, it could be signaling a bearish divergence. This would indicate a forthcoming reversal to the downside.

The money flow index can also be used to identify overbought or oversold conditions in a security. Typically, an MFI reading above 80 suggests an overbought condition, indicating a potential price correction or trend reversal to the downside. An MFI reading below 20 suggests an oversold condition, signaling a potential price rebound or trend reversal to the upside.

Money flow index vs RSI

The money flow index shares similarities with another popular indicator, the relative strength index (RSI). The RSI also measures the momentum and speed of price movements, but it doesn’t include trading volume.

While both indicators have their merits, the MFI's volume-weighted nature can provide additional insights into market dynamics. It offers a more comprehensive view of buying and selling pressure by considering not only price movements but also the volume behind them.

Using the MFI to identify “smart money” movement

This volume component makes the MFI particularly useful for identifying the participation of "smart money" in the market and distinguishing it from "dumb money.” The terms are used to differentiate between institutional investors (smart money) who trade heavily in the last hour of a session and retail traders (dumb money) who do most of their trading in the first hour of the session.

By looking at the trading volume in these specific periods, you can better reason how both retail and institutional traders are operating in the market. For this reason, the MFI is sometimes referred to as the smart money indicator.

How to use the money flow index indicator

To effectively use the money flow index indicator, traders should consider the following:

1. Confirming trends: The MFI can help confirm the strength of a prevailing trend. When the MFI is rising alongside the price, it suggests that the current trend is supported by strong buying pressure. Conversely, a declining MFI alongside the price may indicate weakening buying pressure and a potential trend reversal
2. Identifying divergences: Divergences between the price and the MFI can be powerful signals. Bullish divergences occur when the price makes lower lows while the MFI makes higher lows, indicating a potential upward reversal. Conversely, bearish divergences occur when the price makes higher highs while the MFI makes lower highs, suggesting a potential downward reversal
3. Combining with other indicators: The money flow index can be used in conjunction with other technical indicators to enhance trading strategies. For example, combining the MFI with the relative strength index (RSI) can provide a more comprehensive analysis of market conditions.

In conclusion, the money flow index is a valuable tool for traders seeking to understand the flow of money in and out of a security over a specified period of time. Its volume-weighted nature and ability to identify potential reversals and overbought/oversold conditions make it a powerful indicator.