The Money Flow Index Explained

The Money Flow Index (MFI) is a crucial technical analysis tool used by traders to gauge the strength and momentum of price fluctuations in various financial instruments, including stocks, currencies, and commodities. This index merges price and volume data to deliver insights about the inflow or outflow of capital into an asset.

Originating from the collaborative efforts of Gene Quong and Avrum Soudack in the 1990s, the MFI enhances the more recognized Relative Strength Index (RSI). While the RSI focuses exclusively on price changes, the MFI adds trading volume into the mix, aiming to provide a broader understanding of market sentiment and potential price reversals.

The calculation of the Money Flow Index involves several steps:

1. Typical Price (TP): Compute the average price for each period by summing the high, low, and closing prices, then dividing by three.
   • TP = (High + Low + Close) / 3
2. Raw Money Flow (RMF): Multiply TP by the volume for each period to determine the raw money flow.
3. Money Flow Ratio (MFR): Establish the ratio of positive money flow to negative money flow over a specified period, typically 14 periods.
4. Money Flow Index (MFI): Normalize the MFR on a scale from 0 to 100 using the RSI's normalization method.

Interpreting the MFI involves examining its value in relation to overbought and oversold levels. The scale spans from 0 to 100, with values exceeding 80 typically indicating overbought conditions, suggesting a potential price correction. Conversely, readings below 20 are generally interpreted as oversold, hinting at a possible upward price shift.

Traders often monitor divergences between the MFI and price movements. For instance, if prices are reaching new highs while the MFI records lower highs, this might suggest weakening buying momentum and a potential price drop. Conversely, if prices are hitting lower lows while the MFI shows higher lows, it may indicate reduced selling pressure and a forthcoming price rise.

Creating and Testing the Strategy

This strategy employs a 2-period MFI with a long-only approach. Below is a graphical representation of a 2-period MFI applied to the QQQ (Nasdaq).

The strategy generates long signals whenever the 2-period MFI drops below 5. The duration for holding is flexible, and positions are exited when the closing price exceeds the previous high at any point. Here’s an illustration of a bullish signal:

// © Sofien-Kaabar

//@version=5

strategy("Custom Strategy NASDAQ", overlay=true)

mfi = ta.mfi(close, 2)

buy_signal = mfi < 5 and mfi[1] > 5

if buy_signal

strategy.entry("Long", strategy.long)

strategy.close(id = "Long", when = close > high[1])

Keep in mind that results are presented before fees, which can vary between brokers. It’s advisable to select a broker with low fees, as this strategy may generate frequent trading signals.