Bull Trap – Using Point and Figure Charts to Avoid False Signals
Trading guides, webinars and stories
Trading guides, webinars and stories
There are all types of trading indicators, but the oscillators category is among the most widely used by technical traders. The most popular among them is the RSI. Everyone has heard about it. There are also many other niche oscillators out there. They aren’t as popular, but often they’re just as efficient, if not more so. One of them is the Money Flow Index (MFI). This guide will dive into the MFI indicator to learn what it measures, its uses, and how to calculate it. Most importantly, we will learn how to read a Money Flow Index chart. That includes examining how to identify overbought and oversold signals more accurately. Now let’s start improving your trading strategy.
The Money Flow Index is an oscillator used by technical traders to identify overbought and oversold markets. The MFI is also applied to help spot divergences, trend reversals, and failure swings.
The indicator takes into account both price and volume information, which is what makes it different from the majority of other oscillators. Especially the Relative Strength Index, which incorporates just price data. Analysts refer to the MFI as a volume-weighted RSI.
The Money Flow Index is based on the idea that volume alone isn’t indicative of the market’s overall state. Instead, investors should look at the market’s response to price changes. The combination of volume and price gives a better representation of the dominant market sentiment.
The MFI is measured in values between 0 and 100 that are plotted as a line. A rise in the MFI indicates an increased buying pressure, while a drop in the index’ value is a sign of growing selling pressure.
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As its name suggests, the Money Flow Index represents the inflow and outflow of money into a particular asset over a certain period of time.
The instrument measures buying and selling pressure by analyzing price and volume data.
When the MFI indicates buying pressure, technical traders talk about positive money flow. On the other hand, if the indicator signals selling pressure, that typically signals an in-flow of negative money.
The money flow ratio (or money ratio) combines positive and negative money flow. Traders typically use it to calculate the value of the Money Flow Index.
The value of the MFI is then plotted on a line, which is why it is considered an oscillator.
The use of the Money Flow Index is to help traders better identify the “enthusiasm” in the market. Alternatively, to provide an exact representation of the sentiment that dominates the particular asset class in the given moment.
Simply put, the MFI is used to find out how and how much a given instrument was traded. It is convenient for traders because it paints buying and selling pressure as simple numerical values that are quick and easy to comprehend.
So how can positive/negative money flow help you when trading?
The Money Flow Index’s primary use is to help traders spot upcoming changes in the price trend. These can be reversals, divergences, failure swings, etc. Getting an exact representation of the price and volume data about particular securities allows traders to better plan their future actions.
For example, if the MFI signals an increase in selling pressure, the trader might consider going short to protect their portfolio from losing value. On the other hand, when there’s buying pressure, seeing the build-up can help you time the market better and capitalize on an uprising momentum.
To find out how to calculate the MFI, let’s first start with the formula. The way to calculate the Money Flow Index is as follows:
Money Flow Index = 100 – 100 / (1 + Money Flow Ratio)
Money Flow Ratio = 14 Days Positive Money Flow / 14 Days Negative Money Flow
Raw Money Flow = Typical Price x Volume
Typical Price = (High + Low + Close) / 3
It is a combination of other formulas, which seem a bit complicated at first, but everything will become clear after going through it a couple of times.
The main thing to remember here is how to calculate positive and negative money flow. Each time price advances from one period to another, we have a positive Raw Money Flow for the next day added to the Positive Money Flow. When we have negative Raw Money Flow due to a decrease in price for the period in question, we add it to the Negative Money Flow.
To better understand how to calculate the MFI, let’s go through the process in a series of steps:
Similar to all leading indicators, the MFI helps traders predict expected market movements better. To do that, they focus on identifying two main scenarios – overbought and oversold markets.
We can identify these markets by looking at the value of the MFI. We measure it on a scale of 0 to 100. Depending on where the MFI stands, the trader can get a sense of whether the particular market is overbought, oversold, or in the neutral zone. That way, they can discover potential trading opportunities to capitalize on.
Usually, values above 80 indicate overbought, while values below 20 signal oversold markets. However, the exact may vary depending on the trader’s strategy and the market conditions.
Bear in mind that overbought and oversold signals from the MFI shouldn’t be considered your sole reason for trading. Always look for confirmation from another indicator, since the MFI may remain in the overbought/oversold zone for extended periods during strong trends.
Let’s look at how to read the MFI in both scenarios:
Generally, a security is considered overbought if the MFI is above 80. The MFI can go up to 100, although moves above 90 are pretty rare in today’s markets. However, if the MFI goes above the 90-mark, then you can consider the signal pretty strong.
When the MFI ranges in the zone between 80 and 90 (preferably falling from 90 to 80), traders consider it an overbought market and usually open short positions.
Overbought situations arise when the momentum and the price increase at a pretty fast rate and surpass the 80-mark. Or, in other words – when the price reaches a high point pretty quickly.
When analyzing the signals from the MFI, it is essential to keep an eye on the price movement. If, for example, the MFIs value is very high and starts falling below the 80-mark while the price of the instrument continues to climb, then a price reversal to the downside is very likely to occur.
A security is considered oversold if the MFI is below 20. Bear in mind that, although the MFI rarely drops below 10, when it does, most traders consider it a pretty strong signal.
When the Money Flow Index moves from 10 to 20, traders consider this an oversold market and open long positions.
Oversold situations arise when the momentum and the price go down at a pretty fast rate and surpass the 20-mark. Or, in other words – when the price drops to a very low level pretty quickly.
A situation where the MFI climbs towards the 20-mark while the price of the instrument continues to decrease indicates a potential upcoming upside price reversal.
Okay, but what to make of the MFI when it is outside of the overbought and oversold areas?
For example, when the security is in an uptrend, and the MFI drops below 20 or 30 just to climb above once again. This is a sign that the pullback is over, and the price increase will continue. So is the case with downtrend movements. A short-term rally that pushes the MFI to 70 or 80 but then drops back below traders often consider it a signal to open a short position.
Here is an example of oversold and overbought opportunities on a chart:
The red boxes and arrows mark overbought MFI signals that kick-start bearish trends. On the other hand, the green box and arrow indicate an oversold market that starts a bullish trend.
Money Flow Index-based trading strategies can prove very efficient, judging by some studies. For example, the Optimization and Testing of Money Flow Index study conducted over the biggest companies in the S&P 500 (Apple, IBM, Microsoft, Exxon Mobil, etc.) concluded that a trading strategy based on the MFI could prove more profitable than a simple buy-and-hold strategy. The study also suggests that the MFI parameters proposed in the literature and applied in the mainstream trading world aren’t a universal solution. The authors suggest that you adjust the parameters depending on the situation (trading instrument).
Now, let’s look at how you can use the Money Flow Index in your everyday trading activity.
A divergence in this context occurs when there is a difference between the price action signals and the direction of the MFI. Once the trader spots such a signal, he adjusts his positions depending on whether it is bullish or bearish.
A bullish divergence is when the price marks a new low, while the MFI marks a higher low. When you identify a bullish divergence, you should expect a decreasing selling pressure. This is an excellent time to go long as you will be buying your preferred securities at lower prices.
On the other hand, a bearish divergence is when the price marks a new high, while the MFI marks a lower high. This situation implies that the buying pressure is getting weaker, and sellers are about to take over. Hypothetically this is an excellent time to sell and profit before the price goes down.
As you can see in the example above, right after the divergence signal, the trend nose-dives.
Often, a divergence can show up in waves on both the price action and the MFI charts. For example, if the AAPL stock peaks at $110, then pulls back to $108, and finally goes up to $114, it means it has hit two successive highs. In this case, you should watch out for the MFI. If it makes a lower high when the price hits $114, it means the indicator doesn’t confirm the price action. This can be a sign of an upcoming price drop.
Bear in mind that contradicting signals between the MFI and price action that results in a divergence won’t always mean trend reversals. In some cases, the MFI can produce false signals. Aside from that, it is worth noting that not all trend reversals are accompanied by a divergence. That is why it is essential to have a good risk management strategy in place and not rely solely on the signals generated by the MFI.
Similar to divergences, failure swings can also lead to a price reversal. There are two types of failure swings – bullish and bearish. The common between both is that they unfold in quite a similar way. Let’s see how it works in both scenarios.
As you can see, in both scenarios, the failure swings are identified only based on the MFI and not price action.
Bullish failure swings are considered good buying opportunities, while bearish failure swings are good moments to sell.
Traders capitalize on these scenarios by buying/selling once they confirm the failure swing. In the examples mentioned above, the confirmation comes after step 4 for both situations.
MFI failure swings trading is pretty similar to the typical trend pullback signals. In this case, we have an additional movement of the MFI back to the 80/20 level after it had already surpassed them. The difference is the second movement fails to materialize the same way a pullback does, and the indicator reverses its direction.
The majority of beginner traders’ main problem is how to navigate the abundance of indicators to complement their trading goals. In the case of oscillators and volume-tracking indicators, various tools can help improve your trading efficiency by generating oversold and overbought signals.
Let’s take a look at how the Money Flow Index compares to two of the most popular indicators – the Relative Strength Index (RSI) and the On-Balance Volume indicator (OBV):
Both indicators are constructed in quite a similar way. The RSI and the MFI both look at up days against total up and down days. Similar to the MFI, the RSI is also used to chart the strength and the weaknesses in the price movements. It is based on the closing price for the recent period and generates overbought and oversold signals to help traders find trading opportunities.
However, this is where the similarities between both indicators end. The difference between the MFI and the RSI is that the latter doesn’t consider volume data. This means both indicators look at different things, accumulated during the observed period. While the MFI looks at volume, the RSI looks at price changes. That is why many refer to the MFI as volume-weighted RSI. This basically means the MFI is the more complete indicator, although the RSI is the most popular one.
Aside from that, the Money Flow Index is a leading indicator, which means it provides earlier signals.
Luckily this is not a contest, so there is no point in judging which one is better. In fact, most traders incorporate both indicators in their strategies to get stronger confirmations.
Both indicators compare trading volume for rising and falling periods. The core difference, however, is that the MFI puts more weight on the price action. The Money Flow Index uses it as an absolute criterion and doesn’t acknowledge the length of the period that has contributed to the price change. For example, a period that has led to a 25% price jump is just as important as a period contributing to a 0.5% increase.
Aside from that, another difference is the way both indicators display results. In the case of the OBV, you get an absolute value, while the MFI is displayed on a scale between 0 and 100.
Besides, the value of the OBV indicator isn’t as important as in the case of the MFI. With the OBV, traders emphasize the slope and the direction of the plotted line, instead of the numerical value of the indicator.
Choosing which one to use depends on what you value more. For example, if you want a volume-based indicator with as little influence from price action as possible, then the OBV is the better choice. On the other hand, if you think price action is essential for your trading strategy, go with the MFI.
Of course, you can always combine the indicators to get a more complete representation of the market situation.
The MFI can be a very helpful tool in the process of identifying oversold and overbought signals. Although there is the sense that the MFI lives in the shadow of the RSI and often is an underrated indicator, many traders who get to its core start acknowledging the benefits it brings.
Due to its relative accuracy and straightforward approach, over time, the Money Flow Index has become a popular choice for all types of traders, from beginners to professionals.
However, just like any other technical trading indicator, you mustn’t base your trading decisions solely on the signals generated by the MFI. It can produce false signals, and if not complemented with an additional indicator, can end up losing your money.