MFI (Money Flow Index): Definition and Interpretation for Crypto Trading
The Money Flow Index (MFI) is a popular technical analysis indicator that uses price and volume to measure the evolution of money flows into and out of an asset and to identify the primary sentiment of investors (strength of buying or selling pressure). It is generally considered as a twin to the RSI indicator, but with volume included in its calculation. As such, it is a more complex and complete indicator.
The History of the Money Flow Index (MFI)
The Money Flow Index (MFI) is a technical analysis indicator developed by Gene Quong and Avrum Soudack in the 1980s. The MFI is a momentum indicator that measures the strength of money flowing in and out of an asset, such as cryptocurrencies, over a specified period. By combining price and volume data, the MFI provides traders with valuable insights into market sentiment and potential trend reversals. The MFI has become a popular tool among traders due to its ability to identify overbought and oversold conditions, which can help inform entry and exit points in the market.
What is the MFI indicator?
The MFI is a bounded oscillator evolving between 0 and 100 can be used to highlight extreme price situations, including overbought areas (when the MFI hits above 80) and oversold areas (when the MFI drops below 20). As a momentum indicator, the MFI can also be used to identify trend changes through divergences between the indicator and the price of the asset on which it is based.
How to calculate the MFI indicator?
The calculation of the Money Flow Index is quite similar in nature to the Relative Strength Index. The first thing to do is to select a number of periods. Typically, the MFI is calculated over 14 candles, however, it is possible to augment or to reduce the number of candle to respectively produce more or less sensitive signals. Four steps are necessary in order to calculate the MFI indicator.
- First, you need to calculate the Typical Price for each period. The Typical Price of an asset is calculated by adding the high, the low and the close prices of a period, and dividing the result by 3. If the Typical Price of a period is higher than the Typical Price of the previous period, the money flow is considered positive. Conversely, if the Typical Price of a period is lower than the typical price of the previous period, the money flow is considered negative.
- Second, calculate the Raw Money Flow for each period. The Raw Money Flow is calculated by multiplying the Typical Price of the period by the exchanged volume of the asset. If the money flow is negative, multiply the result by -1 to obtain a negative number.
- Add up the positive money flows together and the negative money flows together for all the periods, and compute the ratio of these two sums. This gives the Money Flow Ratio.
- Finally calculate the Money Flow Index, by substracting 100 divided by the sum of 1 plus the Money Flow Ratio to 100.
Here are the required formulas: Typical Price = (High + Low + Close) / 3 Raw Money Flow = Typical Price * Volume Money Flow Ratio = X Period Positive Money Flow / X Period Negative Money Flow Money Flow Index = 100 – 100 / (1 + Money Flow Ratio) |
How to trade with the Money Flow Index?
The MFI can be used to identify potential entry and exit points in the cryptocurrency market. For example, when the MFI is above 80, it indicates that the market is overbought and a potential sell signal may be present. Conversely, when the MFI is below 20, it indicates that the market is oversold and a potential buy signal may be present.
Spotting overbought and oversold situations with the MFI
As we have mentioned above, the MFI indicator gives oversold and overbought signals. If the MFI or Money Flow Index is above 80 – although this number is set arbitrarily -, then the asset would be considered overbought. The price rose too intensely, or for too long, indicating that the it may soon change direction. If the MFI is below 20 – then again, this number is set arbitrarily -, then the asset would be considered oversold. Conversely, the price dropped too intensely, or for too long, allowing traders to expect a trend reversal. Traders might choose other limits than 20 and 80 to produce signals. The further the limits are from 50, the rarer yet the stronger the signals are. 30/70 marks will produce more numerous but less accurate signals than 20/80 marks.
Spotting divergences between the price and the MFI
Divergences are a major concept in the interpretation of the MFI indicator and other volume indicators. A positive divergence occurs when the MFI rises while the price of the asset falls. Positive divergences suggest a probable bottom and a reversal of the stock’s trend.
A negative divergence is when the MFI falls while the asset’s price rises. This divergence suggests a probable top and reversal of the asset’s trend.
The 4h candlestick chart above is the ETH/USDT market, with the 14-period MFI line underneath. We can see that on the left hand side, the price continues to rise when the MFI slowly drops, creating a negative divergence. Predictably, the prices of the asset reaches a top before dropping. On the right hand side, the MFI is slowly going up while the price continues to drop. ETH eventually reaches a low, before turning bullish.
What is the difference between the Money Flow Index and the Relative Strength Index?
The Relative Strength Index (RSI) is a technical oscillator used to define the strength or weakness of price changes based on the closing prices of a recent trading period. Both the RSI and MFI provide overbought and oversold signals that can be used by traders to open and close positions. The difference between these two indicators is that the RSI does not take volume into account. This is why the MFI is often referred to as the volume weighted RSI. The MFI is considered to provide earlier signals than the RSI because it is a leading indicator. However, there is no consensus as to which indicator is better. Many traders use both to confirm signals.
Below the BTC/BUSD 1-day candlestick chart above are drawn the 14-period MFI line and the 14-period RSI line below it. We can see that the MFI generally enter its overbought and oversold zones earlier than the RSI. Thus, traders can spot MFI overbought or oversold signals, and wait for RSI to confirm the signal to enter long or short positions.
Using the Money Flow Index in conjunction with other technical analysis indicators
There are many different types of technical analysis tools and indicators that can be used to analyze the cryptocurrency market. Some of the most popular tools and indicators include the Relative Strength Index (RSI), Moving Average (MA), Bollinger Bands (BB), Parabolic SAR (PSAR) and Stochastic Oscillator (SO). Each of these tools and indicators can be used in combination with the MFI indicator to provide improved market analysis.
- Relative Strength Index (RSI): The RSI is a momentum indicator that measures the magnitude of recent price changes to identify overbought and oversold conditions. It can be used in combination with the MFI indicator to confirm potential trend reversals. When the RSI is above 70, it indicates that the market is overbought and a potential sell signal may be present. Conversely, when the RSI is below 30, it indicates that the market is oversold and a potential buy signal may be present.
- Moving Average (MA): The MA is a trend-following indicator that is used to identify the direction of the trend. It can be used in combination with the MFI indicator to confirm existing trends. When the MFI crosses above its moving average, it indicates that the trend is bullish and a potential buy signal may be present. Conversely, when the MFI crosses below its moving average, it indicates that the trend is bearish and a potential sell signal may be present.
- Bollinger Bands (BB): The BB is an envelope-style indicator that is used to measure volatility. It can be used in combination with the MFI indicator to identify potential breakouts and reversals. When prices break out of the upper band, it indicates that prices are likely to continue rising and a potential buy signal may be present. Conversely, when prices break out of the lower band, it indicates that prices are likely to continue falling and a potential sell signal may be present.
- Parabolic SAR (PSAR): The PSAR is a trend-following indicator that is used to identify potential reversals in price. It can be used in combination with the MFI indicator to identify potential entry and exit points. When prices are above the PSAR line, it indicates that prices are likely to continue rising and a potential buy signal may be present. Conversely, when prices are below the PSAR line, it indicates that prices are likely to continue falling and a potential sell signal may be present.
- Stochastic Oscillator (SO): The SO is a momentum indicator that measures the speed and direction of price movements. It can be used in combination with the MFI indicator to confirm potential trend reversals. When the SO crosses above 80, it indicates that prices are likely to continue rising and a potential buy signal may be present. Conversely, when the SO crosses below 20, it may indicate that prices are likely to continue falling.
Conclusion on the Money Flow Index (MFI)
In conclusion, the Money Flow Index (MFI) is a valuable technical analysis tool for cryptocurrency traders, providing insights into market sentiment and potential trend reversals by measuring the strength of money flowing in and out of an asset. The MFI helps traders identify overbought and oversold conditions, which can signal possible entry and exit points in the market. When used in conjunction with other technical analysis tools and indicators, the MFI can improve trading decision-making and risk management in the volatile cryptocurrency market.
Frequently Asked Questions about the Money Flow Index (MFI)
1. How does the Money Flow Index (MFI) work?
The Money Flow Index (MFI) is a momentum indicator that measures the strength of money flowing in and out of an asset by combining price and volume data. The MFI is calculated using the typical price (the average of high, low, and closing prices) and the raw money flow (typical price multiplied by volume) over a specified period. The MFI ranges between 0 and 100, with readings above 80 and below 20 indicating overbought and oversold conditions, respectively.
2. How can I use the MFI to identify overbought and oversold conditions in the cryptocurrency market?
When the MFI reaches a value above 80, it indicates an overbought condition, suggesting that the asset may be overvalued and due for a price correction. Conversely, when the MFI falls below 20, it signals an oversold condition, implying that the asset may be undervalued and due for a price increase. It is essential to use other technical analysis tools to confirm the signals generated by the MFI to avoid false breakouts and whipsaws.
3. How can I combine the MFI with other technical analysis tools for better results?
The MFI can be used in combination with other technical analysis tools, such as Simple Moving Averages, RSI, Stochastic Oscillator, or candlestick patterns, to corroborate signals and filter out false breakouts. For example, traders can use the MFI in conjunction with support and resistance levels or trendlines to validate potential trend reversals. Additionally, combining the MFI with other momentum indicators, such as the RSI or Stochastic Oscillator, can provide further confirmation of overbought or oversold conditions and improve the overall accuracy of trading signals.
4. Can the MFI be used on different timeframes?
Yes, the MFI can be applied to various timeframes, such as hourly, daily, or weekly charts, depending on your trading style and preferences. Short-term traders may find the MFI more useful on shorter timeframes, like hourly or 15-minute charts, to capture quick price movements. On the other hand, long-term traders might prefer using the MFI on daily or weekly charts to identify broader market trends and potential trend reversals.