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? Particularly in the Forex market, which is decentralised and, therefore, not overly transparent.
Fortunately, there are various technical indicators designed to help with this problem, one of which is the Money Flow Index, or MFI, indicator. In this article, we will tell you all about this useful Forex indicator, including how to use MFI indicator, how to create a Money Flow Index strategy and much more!
Table of Contents
What Is the 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 divergences, which can signal a change in direction of price. But we will look at that in more detail later. Firstly, let’s look at how to calculate the Money Flow Index.
The Money Flow Index Calculation
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 calculation 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 Money Flow Index calculation is to define a concept called typical price (TP), the value of which equates to the mean 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 the 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 Money Flow Index is calculated with the following equation:
|MFI = 100 – 100⁄(1 + MR)|
How to Use the MFI Indicator in MetaTrader 5
As mentioned already, fortunately, with trading platforms such as MT4 and MT5, you don’t need to worry about actually calculating the MFI indicator yourself.
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 you want the indicator to operate over.
The default MFI indicator settings use a ‘Period’ value of 14 and it is recommended to start with this value whilst getting to grips with the indicator. Once you are more comfortable with the Money Flow Index, you might want to experiment with different settings to see what works best for you.
How to Read the 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 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 used 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 Money Flow Index 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 the trading signals which would have been generated by this MFI trading strategy. Two buy signals are highlighted in green, whilst three sell signals are highlighted in red.
It's worth bearing in mind that no indicator is right all the time and, as such, an MFI trading strategy such as this will produce many false trading signals.
This is why many traders employ more than one indicator in combination, to try and improve their strategy and filter out some of the false signals.
As we have seen, the MFI indicator is a useful tool for identifying potential reversals by demonstrating overbought and oversold conditions as well as detecting divergence.
The Money Flow Index indicator can be an effective part of a trading strategy when used in conjunction with other technical indicators. The best way for you to experiment what combination of indicators works best for you is by experimenting on a risk-free demo trading account.
Trade on a Risk-Free Demo Account
A risk-free demo account is the perfect place to practise your MFI trading strategy without risking your money! Perfect your Money Flow Index strategy in real-market conditions using virtual currency before you head for the live markets. Click the banner below to open your free demo trading account today:
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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.