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.
Divergences
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.
Overbought/Oversold
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. DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.
