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We know intuitively that a trend is made up of price movement as well as trading volumes that went into that price move. When the price of a stock moves up amidst high volumes, there is larger market participation and therefore greater possibility of the uptrend sustaining - at least in the short term. After an initial spurt, if prices continue to rise, but with low volumes, it usually denotes less market enthusiasm in that short term uptrend - in other words lower degree of market conviction in sustaining that uptrend. Usually, this would signify a short term trend change, unless volumes pick up again, perhaps due to incremental newsflow. The same can be said on the way down as well - when prices drop amidst high volumes, the downtrend is assumed to be well underway and will be seen as lasting until such time that the next levels down are accompanied by low trading volumes. This would mean selling conviction in the short run is losing momentum - and could signal a short term trend change.
Looking at a price and volume chart of a stock or of the market, one can try and visually discern such patterns - but that is prone to error. A technical tool that substitutes visual inspection with some statistics is the Money Flow Index (MFI).
Here is how the MFI is computed :
- Each trading day's "typical price" is calculated as the average of high, low and closing price
- Typical price is multiplied by volume of the day to arrive at money flow for the day
- Money flows are divided into positive money flows and negative money flows. When the typical price of a day is lower than that of the previous day, it is classified as negative money flow. Vice versa for positive money flow.
- The Money Flow Ratio is computed by looking at the last 14 trading days money flow data. The total of positive money flow values divided by the total of negative money flow values gives the Money Flow Ratio.
- The Money Flow Index is derived from the formula : 100 - 100/(1 + Money Flow Ratio)
Lets not worry too much about the computation aspect - there are free tools available on the net that compute the MFI for stocks and market indices. Lets focus more on understanding how to use MFI. An index level above 80 is usually construed as overbought - which normally signals that the uptrend is getting unsustainable, and a correction could be round the corner. Similarly, an index level of 20 or below usually denotes an oversold condition in that stock or market index, which usually means that an uptrend may be round the corner. The caveat here is that in extreme cases - ie when markets are in a very strong bull phase, the index level can go beyond 80 and even upto 90, before a correction sets in. Likewise in a very strong bear phase, the index can go down to perhaps 10 before a corrective rally emerges. Such instances are rare - and the 80-20 levels are usually seen as good indicators of likely short term trend changes.
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