How to Trade with the Money Flow Index Indicator
Markets are moved by supply and demand. When supply outstrips demand, prices fall, and when demand outstrips supply, prices rise. But how can we gauge what is happening with supply and demand in the Forex market?
There are various technical indicators designed to help with this problem, one of which is the Money Flow Index indicator. In this article, we will explain how to use MFI indicator, how to create a Money Flow Index strategy and much more!
Table of Contents
What Is Money Flow Index Indicator?
The Money Flow Index indicator is an oscillator which uses historic price and volume data to evaluate the flow of money into and out of a trading instrument over a period of time.
As such, it measures the enthusiasm of the market towards an asset and can be used to help spot overbought and oversold market conditions. Furthermore, the MFI indicator can also be used to identify divergences, which can signal a change in direction of price.
But we will look at how to read the MFI indicator in more detail later. Firstly, let’s look at the Money Flow Index calculation.
The Money Flow Index Formula
There are a number of steps involved in the Money Flow Index calculation. Fortunately, with both MetaTrader 4 (MT4) and MetaTrader 5 (MT5) you can simply add the MFI indicator to your price chart and it will automatically calculate the values for you, meaning you do not need to worry about how to calculate the Money Flow Index yourself.
However, understanding the steps involved in the Money Flow Index formula will help you better understand what the indicator is showing you, and is therefore useful if you plan to use an MFI trading strategy.
The first step of the calculation is to define a concept called typical price (TP), the value of which equates to the mean average of the high, low and closing prices for the period in question.
| TP = (H + L + C) ⁄ 3 |
We are then able to go on and calculate the Money Flow (MF), which is defined by multiplying typical price by volume.
| MF = TP x V |
The next step is to calculate positive and negative money flows over N periods. Positive money flow is defined as any period where TP is higher than the previous period. Conversely, negative money flow is any period where TP is lower than the previous period.
To calculate the positive money flow over N periods, we total the positive money flows over that time span and the same is done for the negative money flows. The ratio of these two numbers provides the Money Ratio (MR).
| MR = Positive Money Flow ⁄ Negative Money Flow |
Finally, the MFI can be calculated using the Money Flow Index formula below:
| MFI = 100 – 100 ⁄ (1 + MR) |
How to Use Money Flow Indicator MT4 & MT5
The MFI technical indicator is one of many which come as standard with both the MT4 and MT5 trading platforms. In both platforms, it can be found in the ‘Volumes’ folder within the ‘Indicators’ section, as shown below.
When you select the indicator, you will be shown the MFI indicator settings dialogue box shown above. This allows you to select the time period which you want the indicator to operate over. The default MFI indicator settings use a ‘Period’ value of 14.
It is usually recommendable to start with the default value whilst getting to grips with the MFI and other technical indicators. Once you are more comfortable with the indicator, you might want to experiment with different settings to see what works best for you.
How to Read MFI Indicator
The Money Flow Index can be used to identify when the market is overbought or oversold. Values lower than 20 usually suggest an oversold market, whereas levels higher than 80 suggest an overbought market.
These levels are marked on the chart as a grey dotted line. Conventional trading wisdom contends that there is an increased chance of a reversal when the market is overbought or oversold. The image below shows an hourly GBP/USD chart with the Money Flow Index indicator plotted below.
As well as being used to identify overbought and oversold conditions, the MFI indicator can also be used to spot divergences, which can also warn of a potential reversal.
A divergence occurs when the Money Flow Index moves in one direction, whilst the asset’s price moves in the other. For example, if the price is recording higher highs but the MFI indicator is moving lower, a bearish divergence is taking place and this may be viewed as a sell signal.
Conversely, if the price were making lower lows but the MFI was moving higher a bullish divergence would be taking place, which may be viewed as a buy signal.
Money Flow Index Strategy
The MFI technical indicator can also be used alongside other indicators to create a Money Flow Index strategy. An example of this is by combining the MFI indicator with a moving average and using the crossovers as trading signals.
In order to do this, locate the moving average indicator in the ‘Trend’ section of indicators in the Navigator window. Click on the indicator and, instead of dragging it on to the main price chart, drag it on to the Money Flow Index indicator’s chart.
As shown above, in the ‘Apply to’ box, select the options ‘First Indicator’s Data’ and, for this MFI trading strategy example, we have used a 30-period simple moving average.
In the chart above, you will note that we have also added an additional level of 50 within the MFI indicator, alongside the pre-existing 20 and 80 levels.
For this MFI trading strategy, a long position is taken if the MFI indicator crosses above its moving average whilst below the 50 level.
On the other hand, if the MFI indicator crosses below its moving average whilst also above 50, a short position is initiated.
The chart below is the same as the one above. However, we have highlighted some of the trading signals which would have been generated by this MFI trading strategy. Two buy signals are highlighted in green and two sell signals are highlighted in red.
Please note that this MFI strategy has only been provided as an example and has not been tested in real market conditions. Furthermore, remember that no indicator is right all the time and, as such, a Money Flow Index strategy, such as this example, will produce many false trading signals.
This is why many traders often employ more than one indicator in combination, to try and improve their strategy and filter out some of the false signals.
Final Thoughts
As we have seen, the MFI indicator can be a useful tool to help identify overbought and oversold conditions as well as for detecting divergence.
The Money Flow Index indicator can be an effective part of a trading strategy when used in conjunction with other technical indicators. In order to learn which combination of indicators works best for your strategy, it’s recommendable to practise on a demo trading account before heading to the live markets.
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FAQ
What is Money Flow Index in technical analysis?
The Money Flow Index is a technical indicator which attempts the flow of money in and out of an asset using price and volume data.
What does Money Flow Index tell you?
The MFI indicator can be used by traders to identify overbought or oversold levels in an asset. It can also be used to attempt to spot potential reversals in price when there is a divergence between the indicator and an asset’s price.
Is MFI better than RSI?
Neither indicator is necessarily better than the other as they both work in different ways. Whereas the MFI indicator is calculated using both price and volume, the RSI looks strictly at price.
Other Articles You May Find Interesting:
- How to Use the CCI Indicator
- How to Use the Parabolic SAR Indicator
- How to Use the Market Facilitation Index
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
