Tips on Technicals - Money Flow Analysis
By measuring the amount of money coming into or going out from a stock, bond or commodity, supply and demand trends can be qualified. This, in turn, can help identify attractive or overpriced securities. Money flow measures the value of transactions and keeps a running total of the net inflow or outflow of cash.
How Money Flow Works
Money flow analysis is the identification of divergences between trends in price and trends in money flow. Theoretically, as a security or commodity goes up in price, money should be flowing into it. Conversely, as the security or commodity goes down in price, money should be flowing out. The important factor is whether an individual item's money flow is changing relative to its historical and recent levels. Relative, not absolute, slopes of both price and money flow are the key.
Figure 1
When a stock, for example, is trending higher, money flow should be trending higher. This is true about 80% of the time and no real information is added to the overall analysis. Money flow is behaving as is expected. In Figure 1, money flow (line) was rising along with the price (bars) of Eastman Kodak.
However, when a stock is rising and money flow is falling, a bearish divergence exists. Price usually corrects in the direction of money flow. This is because money has been leaving the stock meaning demand has fallen. If there are no buyers at a given level, price will fall to a level where there are buyers. Figure 2 shows that price for Johnson and Johnson was falling while money flow was rising. This bullish divergence was resolved in Figure 3 as price moved higher.
Calculating Money Flow
Money flow is a relatively easy calculation but it relies on tick by tick information. When calculating the money flow for an entire market, such as a stock sector or exchange, it becomes necessary to have a good amount of computer power to keep up. Usually, money flow is used on stocks because per-trade volume is required. If a futures contract or cash commodity has trade volume, money flow would be equally valid.
Figure 2 and Figure 3
The formula is simply the cumulative sum of price times volume on upticks minus price times volume on downticks. Zero (unchanged) ticks are ignored. As we can see now, when more money is changing hands on upticks, money flow is rising and that means that trades are occurring at higher prices. Demand is rising.
When to use it
A money flow signal should not be the only reason to trade. Rather, it is most useful as a trade supporting indicator or opportunity identifying tool. For the former, money flow may provide the added confirmation needed when trend line and oscillator analyses are questionable. For the latter, a divergence seen between price and money flow should lead to a full analysis of the stock or commodity. This is especially useful to money managers keeping track of large numbers of instruments.
Large trades can also distort the analysis, especially for illiquid or low priced items. In the stock market, a non-block version of money flow filters out these large trades of 10,000 shares or more. However, both non-block and total money flow should be used regardless of the item. In other markets, the "block" size will be different.
It is also important to analyze several different time frames. Since money flow is a cumulative sum calculation, the span of data used directly affects the look of the graph and the slope of the lines. The ideal candidate for analysis would show price and money flow tracking each other for reasonable length of time before the two diverge. Items where price and money flow do not track at all, forming the shape of an "X," are not good money flow analysis candidates.
Again, do not use money flow as an exclusive decision making tool. Use it to support other tools or to alert you to opportunities. Confirmation of indicators is the key to good technical analysis.
