Track the Pulse of the Market with the Money Flow Index Indicator
What moves markets? It's a fundamental question that every professional trader should consider – and the answer can be as complicated as you care to make it. Perhaps the shortest answer is supply and demand.
If demand for an instrument is high and supply is short, the price will inevitably rise. If the converse is true, the price will fall. Simple, right? But how can we gauge what is happening with supply and demand? Especially in the Forex market, which is de-centralised and, consequently, not overly transparent. One method we can utilise is to use price data to get a handle on how money is flowing in and out of an instrument.
One of the more popular tools for doing this is the Money Flow Index indicator (MFI indicator). The MFI indicator looks at price changes and tick volume to judge whether the flow is positive or negative. It is similar in some ways to the Accumulation Distribution Indicator. Let's first take a look at how values for the index are calculated.
Calculating the Money Flow Index Indicator
There are a number of steps involved in calculating values for the MFI technical indicator. The first step is to define a concept called typical price (TP), the value of which is set at the arithmetic mean of the high, the low, and the closing prices for the period in question.
- That is: TP = (H + L + C)/3
Using this concept, we are then able to go on and define the related concept of money flow (MF). We define this value by multiplying typical price by volume.
- That is: MF = TP x V
The next step is to calculate positive and negative money flows over N periods. We define positive money flow as being any day where the TP is higher than the previous period. Accordingly, negative money flow is any day when the TP is lower than the previous period. To give us the positive money flow over N periods, we total the positive money flows over that time span. Separately, we do the same for the negative flows to give us the negative money flow over N periods. The ratio of these two numbers gives us the money ratio (MR).
- MR = positive money flow/negative money flow
Finally, we convert this into an index using the following equation:
- MFI = 100 - 100/(1 + MR)
In short, we can sum this up by saying that the MFI is the ratio of positive money flow to the total money flow. If the calculations above seem a little burdensome, don't worry – the good news is that the MetaTrader 4 MFI indicator will take care of all the number crunching for you.
Using the MetaTrader 4 Money Flow Index Indicator
The MFI MT4 indicator is one of the tools that comes as standard with the platform, which means that you don't have to make a separate download if you want to use it. Instead, you just need to look in the list of Indicators, and you will find it in the 'Volumes' folder, as you can see in the image below:
Source: MetaTrader 4 - setting the parameters for the Money Flow Index in MetaTrader 4
When you launch the indicator, you will see the dialogue box (see the screenshot above) which allows you to configure the parameters to your own preferences. Beyond the visual aspects of colour and line thickness, the main settings are 'Period', 'Fixed Minimum', and 'Fixed Maximum'.
The period is the N value in the calculations shown above that defines the time span over which we calculate the positive and negative money flows. The default value is 14. The fixed minimum and fixed maximum define the extremities between which the indicator will oscillate. 0 and 100 are the respective default values, and It is recommended that you operate with these values.
How to Read the MFI Indicator
A basic use of the Money Flow Index is to indicate when the market is overbought or oversold. Values lower than 20 usually suggest an oversold market. Conversely, levels higher than 80 suggest an overbought market. These levels are marked on the chart as a grey dotted line. Conventional wisdom contends that there is an increased chance of a reversal at such points. The image below shows an hourly GBP/USD chart to which we've added the Money Flow Index indicator:
Depicted: MetaTrader 4 - GBPUSD 1 Hour chart with an MFI indicator applied - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
The MFI indicator appears below the main chart. You can see how the value of the MFI drops below 20 in the middle section of the chart. The GBP/USD rate subsequently re-bounds from this oversold period.
Trading with the MFI Indicator
Alongside simply considering overbought and oversold conditions, you also need to look at how the MFI indicator is behaving with regards to the price. This is because divergence between the two can be very important. In other words, you are looking for the times when the price tells one story, but the MFI doesn't follow suit and tells a different story instead. For example, if the price is making new highs and the MFI fails to make new highs, or falls.
This is a bearish divergence and can be used as a sell signal. Alternatively, if the price makes new lows but the MFI fails to set new lows, or rises, this would be a bullish divergence. Another MFI indicator strategy is to apply a moving average (MA) to the indicator and to use crossovers of the main value across the MA as trading signals.
To do this, click and drag the moving average indicator from the 'Navigator' into the actual MFI chart. In the settings, choose 'First Indicator's Data' in the 'Apply to' box. The image below shows the MFI indicator with a 30-period simple moving average applied to it. We've also added a centre line by editing the MFI indicator, and we achieved this by going into the 'Levels' tab and then adding a 50 level to the pre-existing 20 and 80 levels.
Depicted: MetaTrader 4 - GBPUSD Daily chart with an MFI indicator applied - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
For this strategy, we buy if the MFI crosses above its MA, and sell if it crosses below the MA. However, we only trade if the indicator is in a favourable level with respect to the centre line at the time. That is, we only act on a sell signal if the MFI is above 50, and we only buy if it is below 50. It's worth bearing in mind that no indicator is right all the time. In fact, any performance that is better than random can make for a useful tool. This still means that there will be many false signals, which can be frustrating.
This is why many traders employ more than one indicator in combination, so as to improve the performance and help to reduce the number of false signals. For example, you could use conventional pattern analysis to better inform your signals from the MFI indicator. Or perhaps you could combine the indicator with a volatility channel, such as Keltner Channels. To get a wider choice of tools to choose from, why not try the MetaTrader Supreme Edition plugin? It includes Keltner Channels alongside a wide variety of other indicators and enhancements for the MetaTrader 4 and MetaTrader 5 trading platforms.
MFI Forex Indicator – Conclusions
As we have seen, the MFI indicator is a useful tool for gauging buying and selling pressure caused by the flow of money into and out of a particular market. A simple use of the indicator is to identify potential reversals at the times when oversold or overbought values are shown. This can be made even more effective by checking for divergent behaviour between the price and the indicator.
The best way to discover which particular method is most effective for you is by trying out the various techniques in the risk-free environment available with a demo trading account. That way, you can see what works with real live prices, but without the fear of losing money while you are still finding your feet. This will stand you in good stead when you embark fully on your trading career.
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About Admiral Markets
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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.