what is the money flow index?

The Money Flow Index was created by Avrum Soudack and Gene Quong as a technical indicator to measure buying and selling pressures in markets. It is an oscillator type of indicator and unlike the similar Relative Strength Index (RSI) it uses both price and volume. Some traders know the MFI as the volume-weighted RSI. The first calculation to determine the Money Flow Index (MFI) creates a typical price for each period. The creators use a 14-day average to create the typical price. When the typical price is rising the money flow is considered to be positive, and conversely when the typical price is falling money flow is considered to be negative. Once positive and negative money flow is determined a ratio of the two is created and added to the RSI formula to create an oscillator with a range of 0-100. Because the MFI is tied to both price and volume its best use is in identifying price extremes and potential reversals.

Interpretation of the Money Flow Index

Interpreting the MFI isn’t so different from interpreting the RSI since the MFI is simply an RSI with volume weighting. The difference is that because volume is added to the calculation the MFI tends to lead prices even more than the RSI. This is helpful in determining overbought and oversold levels in assets before reversals occur, but the MFI can also give more false signals due to the increased lead in prices. Just like the RSI any reading over 80 in the MFI is considered to be overbought, while readings under 20 are considered oversold. Of course any strong trend can cause problems with this interpretation since assets can remain either overbought or oversold for a long period during strong trends. Money Flow Index creators Quong and Soudack have recommended that overbought and oversold levels for the MFI be expanded to 90 and 10 respectively to fully capture these levels. A move above 90 or below 10 is rare and most assets will trade for long periods without trading above 90 or below 10. However, once these levels are reached prices are at extreme levels and are more likely to reverse quickly. Traders can use scanning engines to alert them of these extreme levels.

In Conclusion

By combining price and volume in a single indicator, Quong and Soudack have truly created something unique in the realm of technical indicators. While the similar RSI can be used to determine a bullish or bearish bias to markets when it moves above and below the 50 mid-line, the same doesn’t work with the MFI. However, the Money Flow Index is well suited to identifying reversals from overbought and oversold levels. As with any indicator, adding a confirming indicator or pattern analysis can make the signals provided by the MFO more robust.