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Money Flow IndexThe Money Flow Index is a momentum indicator that essentially measures the strength of money flowing in and out of a security. The key behind its effectiveness is the fact that it uses volume as a key component in its calculation. For example, the Relative Strength Index (RSI) is a popular oscillator that is designed to measure the internal strength of a security by comparing the average up days with the average down days over a period of time. It doesn’t however consider the relative volume for the up and down days. Volume is widely regarded as one of the most important confirmation tools available to traders and its use in the Money Flow Index is advantageous. The Money Flow Index can be seen at the base of the chart below.
Just like the RSI, a number of periods must be selected by the user that is appropriate to their style of trading. For example, a short term trader may select something between 10 to 15 days (2 – 3 weeks). The first step in the calculation is to determine the typical price. The typical price is simply the high, low and closing price summed and divided by three. Next, the money flow (not the Index itself) is calculated by multiplying the period's typical price by the volume. If today's typical price is greater than yesterday's typical price, it is considered positive money flow. If today's price is less, it is considered negative money flow. This is a similar concept to the On Balance Volume (OBV) indicator. Positive money flow is the sum of the positive money over the user specified number of periods. Negative money flow is the sum of the negative money over the user specified number of periods. The Money Flow Index Ratio is then calculated by dividing the positive money flow by the negative money flow. The Money Flow Index is calculated using this ratio. There are a couple of ways in which the Money Flow Index can be interpreted and they are similar to the RSI. First, it can be used to identify divergences between the indicator and the price. For example, if the price moves higher over a period of time however the indicator moves lower, a reversal in the immediate future is likely. The indicator may also indicator overbought areas when it is above 80, and oversold when the indicator is below 20.
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