Investment Basics of Money Flow

Money Flow (MF) can be assessed and technically analyzed using various component indicators. These indicators are vital to an investor when deciding when to make entries and exits into a specific trading program. Money Flow, as an indicator, is synonymously used to refer to the Money Flow Index (MFI). It was Marc Chaikin who developed the money flow theorem, using both the price and the volume as a calculating principle of the price action in any trading issue. When the results of a particular trading day or period have been calculated, the numbers are compared with those of previous day or period to establish whether the MF gained or lost for that particular day or period.

The flow can also be calculated using the Relative Strength Index (RSI), which only differs from the MFI in that MFI accounts for both price and volume, whereas RSI only factors price as the variable.

To calculate Money Flow, an investor uses an average price, which increases after every subsequent bar.  He then determines the average price by reducing the average price of each successive bar. The same is repeated for the average volume. These two ranges of values are then systematically indexed so as to calculate the Money Flow and ultimately plot it on a line graph. The calculations should use both the price and the volume so as to provide the different perspectives as opposed to using either volume or price alone. At the very basic level in most flow graphs, the indicator usually shows several dramatic oscillations, which are useful in determining the value of overbought and or oversold conditions.

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If the foregoing definition is far too technical for non-economists, there is a way to explain it in layman’s language, using accumulation and distribution, which actually is used as the momentum indicator in determining Money Flow. Chaikin’s theory was based on the understanding that when a stock closes above its midpoint for a particular trading session, that stock always exhibits an accumulation for that trading. On the other hand, if the distribution for a trading session results when a stock closes at below the midpoint. In this argument, mid point accrues after adding both the day’s lowest and the highest trade and then dividing the sum by two. To finish the calculation, Chaikin then used both price and volume to calculate the graph ranges. So if you want to asses a typical 42-day or 14-day trading period, you will have to add the accumulation or distribution for those 42 days and then divide that sum by the total volume of that period.

In practice, when stocks are purchased at a price higher than on the former trading session, this results to a positive Money Flow as opposed to when the same stock is traded at a lower price during the next trading session and the result is a negative Money Flow. This is further factored on the variable of volumes traded during that same trading period, such that, when more shares are bought during the positive MF than the negative MF, the net money flow becomes positive since it’s indicative that more and more investors were at that time willing to pay the counter premium for that stock. Similarly, a stock is in trouble, big trouble, when the MF is negative and yet the stock’s price and trading volume are on the rise.

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This therefore necessitates the consideration of the Money Flow Index, whenever an investor is considering the sale (exit) or purchase (entry) of a share.  MFI is therefore a basic momentum indicator valuable to investors while determining current trends of a share during the trading decisions of a particular session. In other words, by analyzing both the price and the volume of that stock, MFI acts like a measure of the amount, strength and dependability of the money going into and out of a particular security. Shrewd investors can use MFI to skillfully predict an emerging trend or the reversal of an ongoing trend days before it happens. That is why you will see some investors rush to the counter with the stocks in a particular holding, and a few days later, the same stock collapses or goes into a downward spiral. Others will order all stocks available on the counter for a particular holding and then a few days later the same stock will explode in prices.

[ad#downcont]Today, many types of software have been designed, and are readily available in the market, to help determine the Money Flow Indicator, such as Tradestation 7. It is also advisable to use other indicators in determining entry and exit points besides Chaikin’s model, especially when the midpoint is not distinct or when there are gaps in prices, otherwise the money flow figures will be skewed.

Money Flow Index has a range of between 0 and 100 and as already established above, the calculating formula can be summarized as:

Typical Price  =     (High trade point+ Low trade point + Close trade point) divided by  3

Money Flow Index  =   The share price  multiplied by the traded volume

Money Ratio  = Positive Money Flow (MF> former MF) or Negative Money Flow (MF<former MF)

Money Flow Index = 100 – (100 / (1 + Money Ratio))