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If “volume precedes price” as is often suggested then it should be possible to apply analytical techniques to certain volume attributes that will have some predictive capabilities with regard to future price development. Using various techniques that come under the general heading of money flow analysis it becomes feasible to decide whether a particular security is being accumulated or distributed. A security that is undergoing accumulation can be expected to gain in price and a security that is displaying the characteristics of distribution will probably offer opportunities on the short side. Equally, it can be very informative to see whether there are divergences between the security’s price behaviour and its volume behaviour.

 The Money Flow Index(MFI)
The Money Flow Index is a volume-weighted version of the Relative Strength Index. The indicator compares the total transaction values traded on days with upward price movement to the transaction values traded on days with downward price movement.

The steps involved in calculating the Money Flow Index are:

• Decide on the time window or lookback period of interest 
• Calculate the Typical Price for each of the periods i.e. (High + Low + Close) / 3 
• Determine the total transaction amount or Money Flow for each period i.e. Typical Price * Volume 
• Determine the Positive Money Flow amount: i.e. accumulate a Positive Money Flow amount for each of the periods, within the time window, when the Typical Price moves up from the previous value 
• Determine the Negative Money Flow amount: i.e. accumulate a Negative Money Flow amount for each of the periods, within the time window, when the Typical Price moves down from the previous value 
• Determine the Money Flow Ratio: i.e. Positive Money Flow / Negative Money Flow 
• Determine the Money Flow Index: i.e. 100 - 100 / (1 + Money Flow Ratio)

MFI is most valuable when a security is in a relatively quiet phase of volume and price development. This can best be illustrated with the following example, which proved to be highly profitable, and which arose for Martha Stewart Living (MSO) in late August 2005. The setup for the trade is displayed in Figure 1. Notice especially the price congestion during most of August 2005 in which price activity was confined to a very narrow range between $26 and $27. During this period of price stagnation there is clear evidence of accumulation taking place in the MFI chart segment below the price chart. Also noticeable is the manner in which the steepness of the MFI slope stands in contrast to the much gentler slope of the RSI slope. On August 25th the stock broke out on heavy volume and over the next four sessions moved from $26 to $34.

It is the dissonance or divergence that is revealing and which provides short term trading cues. The pattern can provide us with the foundations for a reliable template or pattern recognition algorithm using the MFI. When price has been trading within a very narrow range for several periods but there is unmistakable evidence of positive money flow indicating accumulation, be prepared for a potentially major price breakout. This is essentially a short term pattern in that one is not monitoring for any longer term evidence of accumulation but rather looking for a trading opportunity that should arise typically within a ten to twenty day period. In the case of MSO the trader who had observed the unusually positive MFI prior to the breakout on the 25th could have achieved a 25% return within four trading sessions.

(click to enlarge)

Another example of a very similar setup can be seen in the chart for AMGN (Figure 2) at the end of June 2005.

(click to enlarge)