How does the Money Flow Index (MFI) indicator work?

If you are looking to find the demand for a financial asset, you need to be able to track monetary flows in and out of the markets.

The Money Flow Index (MFI) indicator is used to measure supply and demand, which is usually the simplest way to determine where a market may be going.

Note that this indicator was initially designed to work with the stock markets, as forex markets are not centralized, and therefore some of the inputs will be different to the original scenarios many traders had been using in equities.

The basic premise is that if demand for a particular currency is high but supply is limited, prices will rise as bidding increases.

This is the same as any other bidding process: if there are more people wanting to own something, people will try to outbid each other.

Of course, the opposite is true as well: when demand drops, sellers have to drop prices to attract buyers. The Money Flow Index indicator is a popular method of viewing how these forces interact with the markets.

The calculation The indicator uses a couple of different mathematical equations in order to find where the market may be ready to go.

The equation seeks to find the ‘Typical Price’ by determining in the mean of the high, the low, and the closing prices for the time period in question.

In mathematical notation:
I.e. the Typical Price equals the high, low, and close divided by three.

The next part of the calculation takes in what is known as money flow.

This takes the typical price and then multiplies it by volume. There’s no way to know in a non-centralized market exactly how much volume is being done, but by using the volume at your broker, you get a fair representation of what the larger market should be.

The next equation:
Or, Money Flow equals Typical Price multiplied by Volume.

The next part of the calculation looks at positive and negative flows over the quantity of periods that the indicator is set towards, known as money ratio.

The indicator defines positive money flow as being any candle where the Typical Price is higher than the previous candle.

Conversely, negative money flow is when any candle has TP lower than the previous candle.

To get the positive money flow for the indicator, the calculation is to add up the total positive money flows over the time span in question.

Ultimately, to get the negative money flow for the indicator, the calculation is of course to add up the total negative money flows over the same time span.

The equation is:
Finally, everything is converted into an index using the following mathematical formula:
 
In other words, the Monetary Flow Index is a ratio of positive money flow into an asset compared to the total money flow.

The indicator of course shows this for you, and you don’t have to do the math behind it, as it is built into the MetaTrader 4 platform. 

The default measurement is 14, meaning that if you are looking at a daily chart, the Money Flow Index is giving you a reading of the last 14 days. If it is on the hourly chart, it is reading the last 14 hours, and so on.

How to attach the Money Flow Index indicator To use the Money Flow Index indicator on the MetaTrader 4 or 5 platform, go to the 'Insert' menu then go to the 'Indicators' submenu, followed by the 'Volumes' submenu, and selecting 'Money Flow Index'. 

The indicator will show up in its own window at the bottom of your platform.



 At this point, you can start to look for opportunities using the Money Flow Index.

Using the indicator  The MFI indicator is used to indicate when a market is overbought or oversold. In the indicator, you will notice there are two levels marked by dashed lines of 20 and 80, with the absolute highs at the 100 level, and the absolute lows are 0.

When the line is above 90, the market is possibly overbought. Conversely, the indicator moving below the 20 level suggests that the market is oversold.

Let’s look at the chart below.

The red arrow points out where the indicator has broken above the 80 level, suggesting an overbought condition. Shortly afterwards, the EUR/GBP pair dropped.

After that, you can see there was a bounce where the blue arrow marks the Money Flow Index dropping below 20.

While there is just a short term bounce, there is a bounce, nonetheless. This can often be filtered by something along the lines of a moving average, or even a trendline.




To summarise:

• The 80 level is where a market enters an “overbought” condition
• The 20 level is where a market enters an “oversold” condition
• The indicator is built into the Metatrader 4/5 platforms, as well as many others
• The default reading will be for the last 14 candles, but can be changed
• The Money Flow Index is often used with other indicators as well

Adding an additional filter  Many traders choose to compliment the MFI indicator with a moving average.

This is because the moving average can keep you on the right side of a trend.

If you are looking for an indication of an overbought or oversold condition within the Money Flow Index indicator, this can be validated by a move above or below a moving average.

Let’s look at the below four-hour chart in the Canadian dollar/Japanese yen currency pair.



 The blue arrow indicates where the Money Flow Index indicator reached the oversold condition. Shortly after that, the price crossed above the 20 exponential moving average, one that is commonly used.

The way to think about this move is that the market had gotten oversold, and then by breaking above a common moving average, it shows that the momentum and trend is starting to change to the upside.

At that point, most traders would enter a position.

Later on, in the same chart, you can see that the Money Flow Index indicator had entered the overbought condition, and the price shortly thereafter fell below the 20 EMA.

That tells you that the shift is starting to gain momentum, and the market starts to fall from there. Ultimately, this keeps you in the loop when it comes to a potential trend change, and then gives you confirmation in a one-two set up.

In another example, we can apply the Bollinger Band indicator to the chart, looking for signs of oversold or overbought conditions from both indicators.




Looking at the chart, you can see where the blue arrows start that the market has broken below the oversold level, followed very quickly by the market breaking below the bottom of the Bollinger Band indicator.

This shows that the market is oversold as far as the Money Flow Index indicator is concerned, but more importantly it is also oversold with both indicators.

By breaking the bottom of the Bollinger Band indicator, it now is two standard deviations below its average price.

With both of these indicators you have the ability to see a slowdown in volume going into the market, and at the same time you can see that the market is statistically farther away from normalcy than it should be.

This almost always sets up for a ‘reversion to the mean’, demonstrated by the moving average in the middle of the Bollinger Band indicator.

However, some people will also aim for the top of the indicator: it boils down to your own personal trading style.