Understand Market Money Flows to Improve Your Day Trading
Money flow indicators combine features of price and volume indicators to help traders gauge where the market sentiment is right now and where it may be going soon. The money flow ratio and money flow index are two money flow indices commonly used in by day traders.
Money flow is closing price multiplied by the number of shares traded. That basic statistic can be manipulated in strange and wonderful ways to generate new statistics carrying even more information about whether the markets are likely to have more buying pressure or more selling pressure in the future.
The first is the money flow ratio, which is simply the total money flow for those days where prices were up from the prior day (days with positive money flow) divided by the total money flow for those days where prices were down from the prior day (which are the days with negative money flow).
Day traders tend to calculate money flow ratios for short time periods, such as a week or ten days, while swing traders and investors tend to care about longer time periods, like a month or even four months of trading.
The money flow ratio is sometimes converted into the money flow index, which can be used as a single indicator or tracked relative to prices for a given period of time. The equation used to figure out the money flow index looks like this:
If the money flow index is more than 80, the security is usually considered to be overbought — meaning that the buyers are done buying, and the sellers will put downward pressure on prices. If the money flow index is less than 20, the security is usually considered to be oversold, and the buyers will soon take over and drive prices up.
In between, the money flow index can help clarify information from other market indicators.