Money Flow Index
In this discussion we will be looking at an indicator we haven't looked at before. This indicator is called the “Money Flow Index'. The money flow index is very similar to the Relative Strength Index however the former is more a volume-weighted version. Generally speaking, the Money flow Index, MFI measures the rate to which money is invested into a security and the rate it is exited from a security.
Calculation
This basic calculation of the MFI is as follows: Firstly you will need to find the 'Typical Price'. This is calculated by adding the intra-day high to the low and the close and dividing this total by 3. This gives you an average price that incorporates the daily range of the share price.
Typical Price = (Day high + Day Low + Day close)/3
After you have this calculation you multiply the 'typical price' by that volume on that particular day.
The MFI attempts to differentiate between volume going into the stock and volume going out of a stock. If the 'typical price' is higher the previous day's typical price then it is considered positive money, conversely if the typical price is lower than the previous days price it is considered as negative money. The MFI is calculated over a specific period of time, usually 14 days, it should be pointed out that the shorter time period used the greater the volatility.
For a 14 day MFI, the positive money over that period is divided by all the negative money in that same time period. This gives a figure called the Money Ratio. Finally, the Money Ratio figure is turned into a number between 0 and 100 by using the following simple calculation:
MFI = 100 - ( 100 / (1 + Money Ratio))
Obviously with computer packages nowadays you wont be required to calculate the MFI. The above analysis is useful in understanding the thinking behind this method. The only thing that traders might want to experiment with is the time period. However, 14 days should be adequate.
How do you use the MFI?
The MFI can be basically used as the RSI is used. Firstly, it can be used for divergence or to identify overbought and oversold stocks.
Divergence basically means that if the MFI is upward sloping and the share price is downward sloping, then there is bullish divergence. This suggests that it is likely that the share price would rise. The thinking behind this is that the MFI is showing that there is more money flowing into a security that out of the security and therefore the share price weakness is only short term and should start heading in the same direction as the MFI.
With respect to the overbought and oversold signals the MFI works the same as the RSI. When the MFI is below 20 it suggests the stock is oversold, when the MFI is over 80 it suggests the stock is overbought.
Example
The daily chart below is of Sonic Healthcare (SHL), from November 2006 to April 2007.
In the chart above notice that the MFI would have been very good in predicting the share price movement. The green rectangles indicate that the share price is either overbought (above the "80" line) or oversold (below the "20" line). The corresponding share price movement indicated by the yellow circles, clearly show that on all three signals the share price correctly moved in the direction identified.
