Money Flow Index

Home , Money flow index, Relative strength, Volume (finance)

In charting, the price is the most important information we have to work with. The market is like a continuous opinion poll in which buyers and sellers have to indicate what they think a share is worth. However, it is not like an ordinary opinion poll, because buyers have to be prepared to put their money where their mouth is, so to speak. The price is what buyers have actually been prepared to pay for the shares they have bought.

The problem with this is that not all buyers are equal. One buyer may be only prepared to buy 100 shares. Another buyer may be prepared to buy a million of the same shares. The buyer of only 100 shares does not have the capacity to move the market very much. However, the buyer of a million shares may have a significant effect on the market.

When a price move takes place, it can be useful to know how many shares have been traded on that move. If the price jumps 5% on a purchase of 100 shares, it is probably not very important. It may be that there were very few sellers at that time and the buyer was in a hurry to do the transaction. However, if the price jumps 20c on transactions that total a million shares, then serious money is being invested into the move.

The number of shares involved in transactions is known by the jargon term volume. Volume means the number of shares traded in a day in the stock market. In some markets it can have other meanings, so be careful in overseas markets and in markets other than stocks.

Some people prefer to use value rather than volume. Value is simply the price multiplied by the volume. If the data stream which shows every price and volume for every transaction is available, it is easy to add up the value of all the transactions for a period, to get the total value. Unfortunately, we usually only have available the volume and some of the prices. Specifically, we have the first price, the highest price, the lowest price and the last price for the day.

There are several ways that value could be estimated from these data. One obvious way is to take the four prices, average them and multiply by the volume.

The problem with determining the value from these data is obvious if we consider two scenarios for a day on which we assume there were only four transactions, namely the first, high, low and last transactions:

Description Price Volume Value Scenario One First 1.30 1,000 1,300 High 1.40 10,000 14,000 Low 1.25 1,000 1,250 Last 1.35 1.000 1,350 Average/Total Av 1.325 13,000 17,900

Description Price Volume Value Scenario Two First 1.30 1,000 1,300 High 1.40 1,000 1,400 Low 1.25 10,000 12,500 Last 1.35 1.000 1,350 Average/Total Av 1.325 13,000 16,550

Thus, on the simple method discussed above, the value would be 13,000 ÷ $1.325 = $17,225. However, depending where the volume occurred in the day, we have two scenarios in which the value varied between $16,550 and $17,900.

It is important to appreciate that using value, when it has to be estimated using certain assumptions, it will be at best an approximation. If there is some kind of underlying bias in the distribution of prices or volume, it can give misleading signals.

It is even more dangerous to use these assumptions on the market index. The market index may be composed of shares that have a price of say $40, others with a price of say 50c and anything in between. Using an average of their prices is scary. For this reason, both the total volume and the total value for the whole market are published every day. The volume is almost meaningless. The value is far more valid data for analysis.

Even with the inherent inaccuracies and potential biases involved in estimating value, some analysts prefer to use value rather than just price when calculating certain indicators. One value indicator that has come into recent popularity is the Money Flow Index. The Money Flow Index is an indicator that is quite similar to the Relative Strength Index, developed in the 1970s by J Welles Wilder Jr and introduced in his book New Concepts in Technical Trading Systems.

The Money Flow Index is best calculated using computer charting software. Nevertheless to understand the indicator, it is best to at least know how it is calculated. There are several steps:

Step One Calculate the typical price for each day.

Typical Price = (High + Low + Last) ÷ 3

Notice that only three of the available prices are used. The first price of the day is not used. The apparent reason for this is that the first price represents so-called “dumb” money – the most frightened or greedy investor acting on overnight news or rumour. In contrast, the trading later in the day is assumed to be by “smart” money, which is reacting rationally to information and does not tend to pay silly prices. Whether you accept this or not is up to you. Obviously it is a broad and pejorative simplification. However, if you do accept that it has a tendency to be true, you would see the Money Flow Index as providing a clue to what the smart money is doing.

Step Two Calculate the Money Flow for each day.

Money Flow = Typical Price x volume

Step Three Decide the time frame for the index, depending on the time frame for your trading or investing. This is the look-back period over which the index is calculated in days.

Step Four For every day, sum the positive and negative money flows over the look-back number of days.

Positive money flow = money flow on the days in the look-back period when the typical price was greater than the previous day.

Negative money flow = money flow on the days in the look-back period when the typical price was less than the previous day.

Ignore days on which the typical price is unchanged from the previous day.

Step Five Calculate the Money Ratio

Money Ratio = Positive Money Flow ÷ Negative Money Flow

Step Six Calculate the Money Flow Index

Money Flow Index = 100 – 100 ÷ (1 – Money Ratio)

Note: The Money Flow Indicator calculation was described in terms of days. It can be calculated for any other period for which high, low, last and volume data are available. Investors would tend to use weeks rather than days.

The Money Flow Index will oscillate between 0 and 100. It is usually displayed in a sub-chart below a price chart.

Interpreting it is easy:

• When the Money Flow Index is near 50, the market is in equilibrium.

• When the Money Flow Index is above 80, there is a high risk that an uptrend will end soon.

• When the Money Flow Index is below 20, there is a good chance that a down trend will end soon.

Below is an example chart:

The chart shows daily price bars with a 7-day Money Flow Index below it, with the 80 and 20 levels marked as dashed lines. Notice how the peaks and troughs in the price tend to coincide with the peaks above 80 and the troughs below 20 on the Money Flow Index.

Some people also use divergences on this indicator as signals.