The Money Flow Index (MFI) is similar to the Relative Strength Index (RSI) but is is volume-based. Instead of measuring the price of a currency pair against RSI, MFI measures volume. During Forex trading, the MFI attempts to quantify the money flow into/out of currency pairs. MFI is a valuable tool for detecting pattern reversals and trend weaknesses.
The MFI is standardised to a 0 - 100 scale. The indicator's default setting is set to 14 periods and is usually applied to the daily chart, which is the most popular time compression among chartist. Volume is often not kept on charting software platform below daily level, so MFI may need to be used on the daily time compression or higher.
Traders who use volume in their analysis often look for divergences between volume and price. If volume is trending one way, while price is trending in the opposite direction, it could be a leading indication of an upcoming change in the direction of the market.
Many technical analysts believe that price follows volume. Therefore, if volume is trending down while the price trend is up, some traders will believe that price is likely to reverse trend to eventually match volume. Since the MFI integrates volume data into it, traders may attribute meaning to divergence between the direction of the indicator and price.
On the MFI, you can notice that there are green and red horizontal lines on the chart. The green line occur at 80 while the red line occurs at 20. It is believed that when the MFI runs above 80, a security is "overbought" while when the indicator is below 20, a security is "oversold".
Based on these two levels, traders would be biased toward long trades when a market is oversold and toward short trades when a market is overbought. Price reversals are, of course, based on the premise of price reversion or distorted market eventually working their way back to normality. If there is a divergence between MFI and the price and this favors the trade.
The MFI should nonetheless never be used on its own as a trade signalling mechanism, and would be used in conjunction with other indicator, tools, and modes of analysis to make better informed trading decisions.
Conclusion is MFI is a momentum indicator that provides insight into how much money is flowing in and out of a security over time. It is designed for traders looking for points of price reversal in a market and would not be a relevant addition to a trend following system. It is recommended that MFI be used in tandem with other price reversal indicators to filter false signals and better its accuracy.
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