The money flow index indicator is an advanced technical indicator available free of charge within most Forex trading platforms. It is plotted directly on a price chart for an easy-to-read visual representation of momentum. Trading with strong market momentum can be the basis of a profitable Forex trading strategy. I have taken a closer look at the money flow index indicator in this article to help you decide whether to use this indicator in your trading as you work towards becoming a more profitable Forex trader.
What is the Money Flow Index Indicator?
The money flow index indicator (MFI) is an oscillator and momentum indicator which produces a single numerical output between 0 and 100. The maximum bullish (upwards) momentum value is represented by 100 while the maximum bearish (downwards) momentum value is represented by 0.
The MFI is often described as a volume-weighted version of the Relative Strength Index. The exact calculation of the MFI will be outlined later in this article. It uses a combination of price and volume, two of the most definite elements of technical analysis, to determine the strength of momentum at any given time. Forex traders typically use the MFI to identify positive and negative divergences between the indicator value and the price action, or to fade (trade a reversal) overbought (above 80) or oversold (below 20) levels.
However, buying or selling based solely on the value of an indicator applied to a single time frame in Forex is a money flow index strategy that I do not recommend, as it is never profitable in the long term. The MFI is best used in more sophisticated ways which I will talk about later in this article.
Since the MFI uses volume and the Forex market is decentralized, accurate volume data is not typically easily available. This makes using the MFI more challenging for Forex traders than equity traders, who have clear volume data available. Some Forex brokers have begun to provide real-time volume data, but such data incorporate only the broker’s internal flow or volume data from their liquidity providers, which does not reflect the entire market. Some Forex traders try to work around this problem by using tick data, on the basis that studies have identified a reliable correlation between tick data and overall market volume.
Note that money flow index indicators built into or added as plugins to the MetaTrader 4 or MetaTrader 5 trading platforms use tick volume to calculate the volume element. As there are a few Forex brokers offering their own volume data, it is possible to find some versions of the MFI indicator which use the broker’s volume data, although they can be difficult to find. There is a third option which is not discussed enough: volume data is available for currency pair futures which are traded over the counter on major U.S. exchanges. This offers the possibility to plug the MFI indicator into currency futures data, while trading the spot Forex equivalent from the MFI indicator data generated by the equivalent currency future. This can work well if you can set it up, although futures are only available on a limited number of currency pairs, mostly the majors.
How to Use the Money Flow Index Indicator (MFI)
I will start by discussing the three types of trading signals the MFI can generate. Before using any technical indicator, I always stress the importance of understanding what indicators can tell traders about price action. Many new traders rush into using indicators without knowing how to apply them effectively. They rely on the simplest principles, which I want to note again, do not generate consistent profits. Otherwise, the retail loss rate of Forex traders would not range between 70% and 85% at most major Forex brokerages.
Here are the three types of trading signals that MFI provides:
1. Oversold and Overbought Levels: When the MFI moves below 20, traders consider the asset oversold. An overbought condition occurs with the MFI above 80. They are the most direct trading signals from the MFI but also the least reliable. Shorter time frames, for example, the M5 or M15 charts, will get more readings below 20 and above 80. The drawback remains reduced reliability. I prefer the MFI on the H1 chart, a middle ground between frequency and accuracy. Some traders wait for the MFI to break out or break down above and below 20 and 80 before entering a trend, as it may suggest the correction or sell-off is near the end, with volume flowing into the asset for a trend reversal.
Here are three examples of the MFI providing traders with oversold or overbought trading signals.
MFI Indicator Showing Positive Divergence
2. Positive and Negative Divergences: I prefer trading divergences, as they provide the most reliable trading signals in my opinion. A positive divergence appears when price action records a lower low, while the MFI, or any other indicator, sets a higher low. A negative divergence forms when price action records a higher high while the indicator sets a lower high. Positive and negative divergences receive their confirmations from failure swings, the third trading signal from the MFI.
3. Bullish and Bearish Failure Swings: While positive and negative divergences remain excellent trading signals, I recommend confirming them with bullish and bearish failure swings. You will lose out on some of the price action, but the reliability increases notably. A bullish failure swing materializes when the MFI moves below 20, then reverses above it, corrects from its peak but remains above 20, and then accelerates to a higher high. A bearish failure swing occurs after the MFI pushes above 80, drops below it before advancing but maintaining its position below 80 before plunging to a lower low.
Below is an example of a negative divergence confirmed by a bearish failure swing, followed by a sell-off in price action.
MFI Indicator Showing Negative Divergence
Here are my recommendations for using the money flow index indicator:
1. I prefer using the MFI on the H1 chart, while taking direction from a higher time frame chart such as the daily (D1) or weekly (W1) time frame, as it provides me with an ideal balance of trading signal frequency and reliability. You can use shorter time frames, which increases the frequency at the expense of reliability. You will get many false signals, and I do not recommend it. It is better to focus on quality trading signals rather than the quantity of them. Traders may use higher time frames to increase reliability. The drawback is low frequency, keeping you sidelined for prolonged periods. In my opinion, the profits you miss being out of the market remain as significant as trading losses.
2. I recommend trading only the most liquid currency pairs for any money flow index strategy because there is more balanced price action. In less liquid currency pairs, lower volume trades may spike or plunge an asset, which can generate false signals. Another added benefit is the lower spread usually available on such currency pairs. As an active trader, I also benefit from volume-based rebate programs, ensuring each trade earns me more cash per pip. Trading costs can make a significant difference over the long run.
3. Be careful when using the 20 and the 80 levels on the MFI for identifying oversold and overbought conditions. I find them very unreliable and do not trade from such an overly simplistic strategy. Instead, I use these oversold / overbought signals as an early indicator that a trend reversal may follow. Once the MFI moves below or above 20 and 80, I monitor the charts for a positive or negative divergence. They are relatively infrequent, but mostly reliable if confirmed by bullish and bearish failure swings.
4. Confirm buy and sell signals from at least one other source. Avoid using identical ones. For example, using the MFI and the RSI together does not make sense, as the indicators are so similar. Use other aspects of technical analysis to decrease the downside risk of your trades. I never take a position without confirming it from two (or ideally three) different sources. Consider support and resistance levels, together with the existing trend, which I determine from the daily or weekly time frame chart.
5. Using the MFI and any other aspect of technical analysis is an art form and not science. Therefore, I recommend studying how the MFI works with each asset you want to trade rather than commit to certain levels. It requires time and patience, but the experience you gain is priceless and will make you a better trader over time.
Here is an example of the MFI staying clear of the 20 and 80 levels but producing reliable trading signals.
Using MFI Indicator Without Overbought / Oversold
6. I caution against MFI-driven Expert Advisors (EAs) because of the complexity of positive and negative divergences as well as bullish and bearish failure swings. Algorithmic MFI trading solutions exit. Regrettably, they are not…