In the previous article of this series, we introduced portfolio management strategies using technical analysis and briefly discussed the relevance of moving averages in discerning trend changes at a stock or market level (Click Here). In range bound markets, the use of technical analysis is increasingly being adopted to help identify trend changes early enough and thus formulate tactical medium term trading strategies to help deliver alpha in client portfolios. In this article, we look at a couple of other popular technical analysis tools that help understand momentum - which is key to making the trend your friend.

Money Flow Index (MFI)

We know intuitively that a trend is made up of price movement as well as trading volumes that went into that price move. When the price of a stock moves up amidst high volumes, there is larger market participation and therefore greater possibility of the uptrend sustaining - at least in the short term. After an initial spurt, if prices continue to rise, but with low volumes, it usually denotes less market enthusiasm in that short term uptrend - in other words lower degree of market conviction in sustaining that uptrend. Usually, this would signify a short term trend change, unless volumes pick up again, perhaps due to incremental newsflow. The same can be said on the way down as well - when prices drop amidst high volumes, the downtrend is assumed to be well underway and will be seen as lasting until such time that the next levels down are accompanied by low trading volumes. This would mean selling conviction in the short run is losing momentum - and could signal a short term trend change.

Looking at a price and volume chart of a stock or of the market, one can try and visually discern such patterns - but that is prone to error. A technical tool that substitutes visual inspection with some statistics is the Money Flow Index (MFI).

Here is how the MFI is computed :

1. Each trading day's "typical price" is calculated as the average of high, low and closing price

2. Typical price is multiplied by volume of the day to arrive at money flow for the day

3. Money flows are divided into positive money flows and negative money flows. When the typical price of a day is lower than that of the previous day, it is classified as negative money flow. Vice versa for positive money flow.

4. The Money Flow Ratio is computed by looking at the last 14 trading days money flow data. The total of positive money flow values divided by the total of negative money flow values gives the Money Flow Ratio.

5. The Money Flow Index is derived from the formula : 100 - 100/(1 + Money Flow Ratio)

Lets not worry too much about the computation aspect - there are free tools available on the net that compute the MFI for stocks and market indices. Lets focus more on understanding how to use MFI. An index level above 80 is usually construed as overbought - which normally signals that the uptrend is getting unsustainable, and a correction could be round the corner. Similarly, an index level of 20 or below usually denotes an oversold condition in that stock or market index, which usually means that an uptrend may be round the corner. The caveat here is that in extreme cases - ie when markets are in a very strong bull phase, the index level can go beyond 80 and even upto 90, before a correction sets in. Likewise in a very strong bear phase, the index can go down to perhaps 10 before a corrective rally emerges. Such instances are rare - and the 80-20 levels are usually seen as good indicators of likely short term trend changes.

A look at the chart above will perhaps show us the value of MFI in making the trend our friend. This is a chart of the BSE Sensex over the last 2 years, with the MFI chart depicted below. Picture yourself back in end February 2012. The Sensex had rallied above 18,000 levels - a strong 3000 point rally in just 2 months. What signals could you look for at that time to suggest whether the uptrend would sustain or no? Clearly the price chart alone would be of little help. However, when you look at the MFI levels, by the end of February 2012, they had gone to the 80 levels and marginally above - which as we now know is normally a red flag - a signal that a trend change is perhaps round the corner. Price action in the subsequent months did prove that the MFI signal worked - and those who followed MFI, could have taken tactical portfolio measures, if they so desired.

Likewise in June 2012, when markets had developed a distinctly bearish overtone and the Sensex slipped back to 16,000 levels, by just looking at the index numbers at that time, it would be hard to predict whether the market would fall more or reverse trend. But a look at the June 2012 MFI levels showed that it was close to the 20 levels - which usually suggest an oversold market that is ripe for a trend change. A decision to go overweight tactically on equities in Feb-March 2012 in your client portfolios based on MFI readings around 20, would have turned out to be a good decision, as the index chart demonstrates. And, for those of you who took that tactical buy decision and have been tracking the MFI since then, you will notice that it came close to crossing the 80 levels only in October 2013, but didn't cross it, allowing you to stay with your tactical long position. For whatever it is worth, the MFI levels on the day of writing this piece (29 Nov 2013 seem to suggest that the market is right now looking more oversold than overbought - which would mean that the uptrend that began in June 2012 is still pretty much intact. In other words, if the trend is a reliable friend, no need to cut your tactical overweight equities position right now - it looks like you can continue remaining overweight equities for now. Only time will tell us whether the trend indeed turns out to be our friend!

Relative Strength Index (RSI)

RSI is conceptually on the same lines as MFI except that it measures the relative strength of a stock or index's move, without as much attention to the volumes aspect as MFI does. For this reason, MFI is often seen as a more comprehensive measure as compared to RSI.

The image above depicts the Sensex over the same 2 year time period, with the MFI and RSI indicators mapped below. An important divergence between the two indicators was seen recently - in October 2013, when the RSI signaled an overbought condition (above 80) when the market scaled the 21,000 level, but the MFI actually kept trending down. What this perhaps suggests is that while the price in itself looked stretched, it was not accompanied by high volumes - in other words, the flow of money was not strong enough in the upmove to suggest a genuinely overbought market which is ripe for a trend change. How then should one use both these signals to make the trend our friend? One way perhaps is to look for a confirmation from both the indicators to take a call whether the market is ripe for a trend change or no. If both indicators are at 20 or below, perhaps its time to go tactically overweight equities, and conversely, if both indicators are above 80, perhaps time to take some profits. Take a look at the image above and decide for yourself whether this double confirmation would have worked well for you in the past 2 years or no.

Share your thoughts and perspectives

Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !

Share this article