Mean Reversion with Money Flow Index (MFI) Divergence
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MFI: The Volume-Weighted RSI
The Money Flow Index (MFI) is often referred to as the volume-weighted RSI. Like the RSI, it is a momentum oscillator that identifies overbought and oversold conditions. However, MFI incorporates volume into its calculation, which makes it a more robust indicator of buying and selling pressure.
For mean reversion traders, MFI divergence is a effective signal to watch for. When the price is making new highs or lows, but the MFI is failing to confirm, it suggests that the trend is losing its underlying momentum and is ripe for a reversal.
The Strategy: Trading MFI Divergence
This strategy focuses on identifying bullish divergence between price and MFI as a signal to enter a long mean reversion trade.
Indicator Settings:
- Chart Timeframe: Daily
- MFI: 14-period MFI
- Moving Average: 50-period Simple Moving Average (SMA) as the mean.
Trade Setup: Going Long on Bullish MFI Divergence
Here is a step-by-step guide to this setup:
- Identify a Downtrend: The stock should be in a clear downtrend.
- Spot the First Low: The price makes a new low, and the MFI moves into oversold territory (below 20).
- Look for Divergence: The price then makes a lower low, but the MFI makes a higher low. This is bullish divergence.
- Confirmation: The divergence should be clear and obvious on the chart.
- Entry Signal: Enter a long position when a candle closes above the high of the candle that made the second low.
- Stop-Loss: Place your stop-loss below the second low.
- Profit Target: Your target is a return to the 50-period SMA.
Example Trade: Buying ABC Stock
Let's examine a hypothetical trade on ABC stock.
| Date | Price Low | MFI (14) | Notes |
|---|---|---|---|
| July 10 | $45.20 | 18 | First low, MFI is oversold. |
| July 15 | $44.50 | 25 | Divergence: Lower price, but higher MFI. |
| July 16 | $45.10 | 32 | Entry Signal: Close above the previous high. |
- Entry: Long at $45.10
- Stop-Loss: $44.40 (below the low of $44.50)
- Profit Target: The 50 SMA, which is currently at $47.50.
Why MFI Divergence Works
MFI divergence is a effective signal because it shows that the selling pressure is drying up, even as the price is pushing to new lows. The higher low on the MFI indicates that there is less money flowing out of the stock on the second low, which is a sign that the sellers are exhausted. This creates a high-probability setup for a bounce back toward the mean.
As with all divergence strategies, it is important to be patient and wait for a clear signal. Do not try to pick a bottom. Wait for the divergence to be confirmed and for the price to show signs of turning before you enter a trade. By using MFI divergence, you can add a valuable tool to your mean reversion trading arsenal.