Monday, January 16, 2017

Follow The Flow of Money

This article was written in 2007. 

What a bull run!  Singapore Stock Market together with the rest of the global indices are breaking record highs after the late February 2007 scare by Shanghai bourse where they fell more than 10% on that fateful day.  The same night, Dow Jones reacted negatively at open but it was a late technical glitch on their system that lead to a massive selling that rocked the markets across the globe in the following weeks.  A lot of money was lost by this sudden debacle as investors sold into panic.  Those who held on to their shares emerge as victors as we saw the market rebounds to great heights.  However, was it blind faith or powerful hoping skills that they emerge as winner?  Market exuberance is notoriously known to puncture any bull run in spectacular fashions.  We are already in the 4th year of the bull market which started in mid 2003.  Along the way, we read and heard warnings about market exuberance and how the bull run would soon end.  However, this bull market’s resiliency caught many bear advocates by surprise as we went on to break new high after new high.  The truth is, no bull run will go on forever.  These bear advocates will be finally right one day after many wrong calls.  However, rather than playing this guessing game or arguing our lungs out with different opinionated fellow investors, we can be well informed to protect our investments.  Knowing a simple indicator known as Money Flow Index will keep us well informed.  The objective of this article will seek to arm the reader with a time tested method in identifying the reversal of an uptrend thus protecting their investments.

The Money Flow Index (MFI) is a momentum indicator that is similar to the Relative Strength Index (RSI) in terms of interpretation and calculation. The only difference is, MFI is volume weighted and hence is a good measure of the strength of money flowing in and out of a stock.  RSI only takes the price actions into calculation and missed out the essential of technical analysis, volume.  Volume combines with price actions will give us a good picture if money is flowing into or out of a stock.  We certainly do not want to be in the dark if money is flowing out of a stock we owned.  MFI compares "positive money flow" to "negative money flow" to create an indicator that can be compared to price in order to identify the strength or weakness of a trend.  It is measured on a 0 - 100 scale and is often calculated using a 14 day period.

The MFI can be interpreted much like the RSI in that it can signal divergences and overbought/oversold conditions. 


Positive and negative divergences between the stock and the MFI often indicate the imminent reversal of a trend.  If the stock price is rising, but there is more volume associated with daily price drops than with the price rises. This suggests a weak uptrend that threatens to reverse as money flowing out of the stock is "stronger" than money flowing into it.  

Figure 1: Negative Divergence between Price and MFI

Figure 1 shows the chart of Jurong Technologies Industrial Corpn Ltd (JurTech) which has depreciated nearly 60% in value.  As the price of JurTech edges higher from May’05 to Sept’05, MFI recorded a lower high reading.  While the uninformed investors are celebrating the new high, well informed investors are wary of the negative divergence happening on the weekly chart.  No prize for guessing who will be able to better protect their investment.  Following the divergence, Seagate made an acquisition of Maxtor who was JurTech major client at that time, market didn’t take the news too well and thus the uptrend reverses and the downtrend began. 

Figure 2: Positive Divergence between price and MFI

In figure 2,  Ouhua prices reach a new low in Mar’07.  However MFI records a higher trough in Mar’07 as compared to late 2006.  This is known as the positive divergence.  While many investors would like to buy cheap, unfortunately, many ended up catching a falling knife where the stock became cheaper after they bought.  The ability of identifying a positive divergence will highly increase the probability of catching a bottom.


As with the RSI, the MFI can be used to determine overbought or oversold.  A stock is considered "overbought" if the MFI indicator reaches 80 and above and a reading of 20 and below suggests a stock is "oversold".  However, when a stock is in a strong trend, it is less likely to have oversold reading.  Similarly, it may stay overbought during a large part of the trend.  Hence it is also important to identify the support or resistance for MFI. 

Figure 3: MFI Support

As shown in figure 3, the uptrend for Capitaland which started in early August was well supported by the MFI.  Each pull back in price is supported by this MFI support.  It must be observed in this trend that MFI did not record a oversold reading for a good eight months.  We know that in a healthy uptrend, price retracement is only good for the overall trend.  Hence whenever the price pulls back and the MFI reaches the support level, investors have a high probability entry signal.

Figure 4: MFI Resistance

Figure 4 showed how the price movement of Seksun was resisted and the MFI had also met resistance.  The first peak of the MFI in Jan’07 showed that the stock price retraced.  Subsequent stock price retracement in late Feb’07 showed that the peak of the MFI also matched the peak in Jan’07.  From here on, we would expect this level of MFI to form a resistance and that price retracement will can be expected.  Hence in late May’07, with MFI trading near the resistance level, it is noted that the stock price was unable to close higher. 

This article has highlighted how MFI can be used to identify weakness in an uptrend or downtrend through divergences.  Readers can now better anticipate and act to protect their investments.  MFI can be further used to identify support and resistance levels where stock price is expected to react thus enable investors to time their entries or exits with higher probability.

This article first appeared in Smart Investor in 2007. 
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