Money Flow Index (MFI)
As a volume-weighted version of RSI, the Money Flow Index (MFI) can be interpreted similarly to RSI. The big difference is, of course, volume. Because volume is added to the mix, the Money Flow Index will act a little differently than RSI. Theories suggest that volume leads prices. RSI is a momentum oscillator that already leads prices. Incorporating volume can increase this lead time.
Quong and Soudack identified three basic signals using the Money Flow Index. First, chartists can look for overbought or oversold levels to warn of unsustainable price extremes. Second, bullish and bearish divergence can be used to anticipate trend reversals. Third, failure swings at 80 or 20 can also be used to identify potential price reversals. For this article, the divergences and failure swings are be combined to create one signal group and increase robustness.
Overbought/Oversold
Overbought and oversold levels can be used to identify unsustainable price extremes. Typically, MFI above 80 is considered overbought and MFI below 20 is considered oversold. Strong trends can present a problem for these classic overbought and oversold levels. MFI can become overbought (>80) and prices can simply continue higher when the uptrend is strong. Conversely, MFI can become oversold (<20) and prices can simply continue lower when the downtrend is strong. Quong and Soudack recommended expanding these extremes to further qualify signals. A move above 90 is truly overbought and a move below 10 is truly oversold. Moves above 90 and below 10 are rare occurrences that suggest a price move is unsustainable. Admittedly, many stocks will trade for a long time without reaching the 90/10 extremes. However, chartists can use the StockCharts.com scan engine to find those that do. Links to such scans are provided at the end of this article.
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JB Hunt (JBHT) became oversold when the Money Flow Index moved below 10 in late October 2009 and early February 2010. The preceding declines were sharp enough to produce these readings, but the oversold extremes suggested that these declines were unsustainable. Oversold levels alone are not reason enough to turn bullish. Some sort of reversal or upturn is needed to confirm that prices have indeed turned a corner. JBHT confirmed the first oversold reading with a gap and trend line break on good volume. The stock confirmed the second oversold reading with a resistance breakout on good volume.
Aeropostale (ARO) became overbought when the Money Flow Index moved above 90 in late September and late December 2009. Extremes in MFI suggested that these advances were unsustainable and a pullback was imminent. The first overbought reading led to a sizable decline, but the second did not. Notice that ARO peaked with the first overbought reading and formed lower highs into October. The late October support break signaled a clear trend reversal. After the December overbought reading, ARO moved above 23 and consolidated. There were two down gaps and a support break, but these did not hold. Price action was stronger than the overbought reading. ARO ultimately broke resistance at 24 and surged back above 28. The second signal did not work.
Divergences and Failures
Failure swings and divergences can be combined to create more robust signals. A bullish failure swing occurs when MFI becomes oversold below 20, surges above 20, holds above 20 on a pullback and then breaks above its prior reaction high. A bullish divergence forms when prices move to a lower low, but the indicator forms a higher low to show improving money flow or momentum.
On the Aetna (AET) chart below, a bullish divergence and failure swing formed in January-February 2010. First, notice how the stock formed a lower low in February and MFI held well above its January low for a bullish divergence. Second, notice how MFI dipped below 20 in January, held above 20 in February and broke its prior high in late February. This signal combination foreshadowed a strong advance in March.
A bearish failure swing occurs when MFI becomes overbought above 80, plunges below 80, fails to exceed 80 on a bounce and then breaks below the prior reaction low. A bearish divergence forms when the stock forges a higher high and the indicator forms a lower high, which indicates deteriorating money flow or momentum.
On the Aetna chart above, a bearish divergence and failure swing formed in August-September. The stock moved to a new high in September, but MFI formed a significantly lower high. A bearish failure swing occurred as MFI became overbought above 80 in late August, failed to reach 80 with the September bounce and broke the prior lows with a decline in late September.
Conclusion
The Money Flow Index is a rather unique indicator that combines momentum and volume with an RSI formula. RSI momentum generally favors the bulls when the indicator is above 50 and
