I was feeling sad and blue, thinking that my Option Investor mail box had been empty too long and low and behold, a mail came in that wasn't taking me to task for any recent bad call or anything (actually there was phrase for 8/12 Index Trader article), so I was glad again and happy to answer the following SUBSCRIBER QUESTION:
"Could you write something about money flow indicators as demonstrating divergence or big money moves in your Wednesday article?"
My first mistaken take on this question was that I don't have a Money Flow Indicator for the stock indexes, because this indicator works both with Price and VOLUME and there is not a usual link between prices of the major stock indexes and volume information; e.g., such as if this indicator could utilize the TOTAL daily volume in the SPX, OEX, DJX and NDX options (for all option exchanges).
Of course, there is the case of the Nasdaq 100 Tracking Stock (QQQQ), which being a stock, DOES have the requisite daily volume tallies. But then I realized belatedly that of course there are key and bellwether individual STOCKS that we can trade within the S&P 500, S&P 100, Nasdaq 100. And, I should of course write about the use of this Indicator pertaining to the question of our OIN Subscriber above.
WHAT IS THE MONEY FLOW INDICATOR?
This technical indicator is usually called the Money Flow Index (MFI) or just the 'money flow' indicator, which is available in various charting and technical analysis applications such as TradeStation, MetaStock, etc. and is essentially a volume-weighted Relative Strength Index (RSI) indicator.
As many of you know who follow my weekend Index Trader columns, I refer to the RSI frequently; see my 8/12 article by clicking here.
RSI, first described by Welles Wilder, is based upon the difference between the average of the closing price on X number (the 'length' setting) of up periods vs. the average closing price on X number of down period; e.g., days.
Wilder in fact used a period of 14 days as an introductory example, but other periods since have also become common. I see the 5 and 10-day setting used a lot. I use mostly the fibonacci 13 and 21 period settings; also, 8 on weekly charts.
In addition to indicating overbought and oversold levels when the indicator goes above the typical 'overbought' reading of 70 or below the typical 'oversold' reading of 30, 'relative strength' can be interpreted using other formulas, of which the MONEY FLOW INDEX (MFI) is one. It's a plus that it brings in volume info.
Traditional chart patterns are sometimes or often observed in the indicator action BEFORE they occur in the price-volume data. Head-and-shoulder tops or bottoms are one of the most reliable of all major reversal patterns and are sometimes or often found at major or at least intermediate junctures, while 'pennants' and 'flags' are continuation patterns that represent a pause in the direction of the current move. Areas of support and resistance often or usually occur in the MFI before they appear in the price action.
In addition, divergences between price action and the MFI (or RSI) may portend a very STRONG or robust turning point. When the stock price continues to rise but the MRI or RSI declines, look for a correction. This also works in the reverse fashion, at bottoms.
MFI attempts to measure money flowing into and out of a security. Money flow is calculated by determining the average price for a particular day and then comparing it to the previous day's average price. If today's average is greater than yesterdays, then the money flow is positive. If it's less, money flow is negative.
Positive money flow is the cumulative positive money flow over the specified number of periods, which is the 'length' setting. The money ratio is the ratio of the positive divided by negative money flow. The MFI is typically calculated as MFI = 100 - (100/(1+Money Ratio))
The indicator is interpreted the same as the RSI (divergences, failure swings and patterns are significant).
Average price is calculated by summing the Open (if available), Close, High, and Low and then dividing the sum by either four or three (three if no Open is available). Positive money flow occurs when todays average price exceeds yesterdays average price, and is calculated by multiplying todays volume by todays average price.
Negative money flow occurs when yesterdays average price exceeds todays average price, and is calculated by multiplying todays volume by todays average price. The positive and negative money flows are then summed over the number of bars specified in LENGTH. The Money Flow Index is then calculated as follows in the TradeStation charting application I use, which is typical:
MFI = 100 - (100/(1+(Sum of Positive MF / Sum of Negative MF)))
MFI VERSUS PRICE ACTION EXAMPLES: DETERMINING OR 'CONFIRMING' TREND REVERSALS
NASDAQ 100 TRACKING STOCK; DAILY CHART (QQQQ):
On the left hand side of the daily chart of the Nas 100 (NDX) index stock below (QQQQ), there is an example of a bearish price/MFI divergence. This using the commonly suggested 'length' setting of 21; this by myself and more public analyst types like Marc Chaikin and he is very good on volume studies by the way.
Back in the November-December time frame as seen in the chart below, QQQQ rallied to a new high, but when doing so, the Money Flow Index fell well shy of a similar new high. Note that the two trendlines slope in OPPOSITE directions, which is visually the easiest way to highlight these DIVERGING trends.
This bearish divergence suggested shorting the new high in the Q's, but it didn't give an exact time frame in which to do this. You have to then look to when the stock STOPS going to new highs and then starts falling, even if gradually. That is the time to go in to the trade. Place a stop or exit point just over the highest high for the shorted stock or to exit puts.
A NOTE ON OVERbought or OVERsold extremes: Getting to an 'oversold' MFI reading, uysually defined as 20 or below and the equivalent of an RSI reading of 30 or below, was too soon to be buyer of the stock for most traders. But waiting to see if a bullish divergence set up was the right indicator 'trigger' to suggest a buy of the stock or a Call purchase; or other bullish strategies like selling puts.
Such a BULLISH Price/MFI divergence did set up as the new (price) low in QQQQ below 36 was accompanied by a HIGHER low in the MFI indicator, suggesting that the stock was under ACCUMULATION, another way of saying that the stock was being bought on balance below 37 dollars.
In the bullish price versus indicator divergence, when QQQQ started stabilizing in the $36 area and starting rising, even though by very little, it was the time to pounce on the stock and buy it.
Why not wait still longer, such as to when the rising trend is more fully apparent? Well, in options, premiums are going to inflate by then. But mostly, you have a 'defined' stop or exit point that is close at hand, which is to just below the lowest low in the stock. You have to assume and here's the great value of the 'oversold' concept, that upside potential for a rebound is substantially MORE than the small amount to just below the lowest low, you are going to risk in a 'normal' trading environment (versus some rare, calamitous, event).
Looking at the Relative Strength Index (RSI) comparison to price action, we see very little difference in the chart above with the way that the bearish or bullish divergences developed in the Money Flow Index.
CISCO SYSTEMS (CSCO):
In recent years Cisco Systems (CSCO) has been one of the key 'bellwether' stocks for the Nasdaq. Note that prices were trending down in July into early August, but the Money Flow Index made a double bottom suggesting that the stock was under some accumulation. The bullish price/RSI divergence was even more clear cut.
Down in the low-$17 area I was an enthusiastic buyer of the stock, setting a sell stop in the stock just under 17.00. I wasn't so convinced that I bought the calls, which were trading very cheap. Oh well! At least I bought the stock in my margin account.
The other thing, and best would if there was always other bullish factors in a bullish trade, was the fact that the stock had been accumulated heavily before in the $17 area. I also figured that institutions were sitting on the stock in that area and would buy more. The MFI would suggest that they did start buying the stock beginning at 17.5.
GENERAL ELECTRIC (GE):
The other more recent (July August) markings and comparison of price action versus the MFI and RSI indicators, show the indicators merely 'confirming' price action. This is often the case in comparing price patterns versus indicator patterns; e.g., new lows are simply 'confirmed' by new lows in the indicators NOT by higher relative highs in the indicators. The divergences are less common, but very valuable as trading guides when they occur!
** Good Trading Success! **