Table of contents:
Behind the money flow is the great idea of uncovering the footsteps of the major market participants. If the trader knows in which direction the big players are trading, then it should be possible to be driven along profitably. This is how one could summarize the theory.
The MFI serves the purpose of following the footsteps of funds and banks. A large fortune cannot be brought in or taken out of a market at any time. Both when a fund enters a market, it drives up the price, and when it exits, it pushes it down. It is therefore no wonder that all major market participants want to hide their trading activities.
In order to learn more about the big players in a market, you have to compare price and volume and draw the right conclusions. The right tool for this is the “Money Flow Index”. In this way, the MFI would be a tool for researching the supply and demand situation.
Basic principle of the Money Flow Index
If a stock frequently closes above its average price, the stock is in accumulation. It is then collected by the major market participants. As soon as a large buyer wants to buy a stock, he does so in several tranches. To ensure that trading intentions go unnoticed, the big player places both buy and sell orders in the market. However, with a superior intention to buy, it is inevitable that the price will often close in the upper part of its trading range. This principle cannot be avoided, especially in intraday trading, as more shares are bought than sold at the end of the day.
The upper picture is intended to illustrate the money flow principle. If the price closes in the upper part of the candlestick, the majority of the security is bought. If the market closes below the middle, we speak of distribution.
The MFI is one of the most accurate of the volume indicators. Nevertheless, it must be smoothed out, otherwise it becomes too fidgety. The standard setting of 14 or 20 has proven to be practical. The MFI combines both a trend statement and an indication in the overbought-oversold range. Depending on the smoothing setting, the extreme values start at 30:70 or 20:80. At the extremes, the market is overheated and a countermovement is more likely.
Interpretation of the MFI(20)
A bullish trend is seen when the indicator value remains above the 50 line for a long time. In an uptrend, the indicator only falls back to the center line and then resumes the uptrend. In an uptrend, the MFI is above the center line for more than 75% of the time.
(The opposite behavior occurs with the downward trend).
The market is overbought when the MFI exceeds the value 80. A countermovement is near. Only in a strong uptrend can it stay above 80 for a longer period of time.
The market is oversold when the MFI value falls below 20. Only in a downward trend does a value of <20 remain for a longer time.
If a break in the trend line can be detected within the MFI, this often results in an early reversal signal. The momentum of the price movement is reversed when a trend line break occurs.
The MFI and RSI are not dissimilar
The comparison of the MFI with an RSI shows the effectiveness of the volume. Both indicators have the same period and scaling. Are also similar in their interpretation. However, within the calculation of the MFI the trading volume is included and this circumstance generates faster indicator movements compared to the RSI.
The MFI is also suitable for short-term trading. With its trend statement, above or below the 50 center line, it is often used as a filter for trading systems. However, the MFI can also generate its own trading signals. Especially trend line breaks in the indicator or divergences to the chart are good approaches.
The MFI trading with trend line breaks
In a volatile market, the MFI generates good entry signals with the help of trend line breaks. The trading trick is the precise selection of support points for a trend line. For this purpose an extreme support point in the Money-Flow-Index is the starting point of the trend line. For a long trade the starting point should be at least greater than 60, and for a short trade less than 40. The more extreme the values are, the better.
The second support point for the trend line should be on the same side (starting from the middle line) as the starting point. Especially trend line breaks near the center line are profitable.
Effect on breaks at resistances and supports
It is known that trading volume has a positive effect on the success of a price breakout. So can the MFI improve trading results during a breakout?
In the example below, the FDAX was selected on a daily basis, and a standard 30-day high was set as the resistance. A long breakout is considered successful if the price is above the resistance on the fifth day. Conversely, the same applies to support for a short breakout attempt.
Note: The procedure for this test is not quite correct, because a 30-day high does not necessarily have to be a resistance. The small error is accepted here because it is not about technical correctness, but a quick test whether the money flow is advantageous for the breakout attempt.
Here are the test results for a longer period of FDAX. The result is similar if the 30 DAX shares are selected as individual test objects.
Test period on a daily basis with FDAX:
01.01.2004 until 31.12.2016
With 4 Euro trading fee per round turn
Comparison result, if the FDAX would be tested without MFI as filter
Hit rate: 51.29% Payoff ratio: 1.04 Profit factor: 1.10 Drawdown: 20%
Total: 1435 trades
Result with MFI(14): A signal is valid if the MFI is long traded over its GDL20 of the MFI. For short trade, the MFI must be below its GDL20.
Hit ratio: 51.65% Payoff ratio: 1.12 Profit factor: 1.19 Drawdown: 19
Total: 1063 trades
Conclusion on the MFI test
The test result shows that the MFI cannot be used to significantly increase the hit rate within an outbreak system.
The reason for this is probably the undifferentiated use of the MFI. The probability of a break increases if the price can run to the trend line with little energy (volume). Only then, at the direct break, is increased volume of advantage. The MFI cannot provide this differentiation. Nevertheless, the test shows a clear difference in the payoff ratio. The payoff ratio results from average profit/loss. It is an indication that a volume-supported break can generate a higher individual profit.