Money Flow Index & OBV
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MFI and OBV are great indicators that confirm existing trends and identify reversals. What I like about the Money Flow Index and On Balance Volume is that they're used to track the accumulation or distribution of a security.
By tapping into volume and price you can see what the institutions are trying to do; hopefully unnoticed. We ignore linear regression analysis or some other formula invented by an Italian mathematician in the 1700’s and get down to basics. Who's buying what, how much of it and what price.
MFI is used to determine the strength of money flowing in or out of a stock. Based on this we can confirm whether the security is in a confirmed trend or about to have a reversal.
Money Flow Index is similar to the Relative Strength Index. The difference being MFI accounts for price and volume while RSI uses only price to identify strength and weakness.
MFI signals range from 1- 100. The closer the signal is to 100, the stronger the accumulation. If the signal line dips below or near 20, then starts its way up, we are in oversold territory. Just like stochastics, the signal says the stock is temporarily undervalued and buyers may be swooping in.
Similarly, when the signal goes to 80 and drops, we’ve entered overbought territory. Traders will be looking to take profits since they feel the stock is not going higher and headed for a downturn. These are not long term assumptions. Traders are looking at oversold & overbought as short-term plays.
However, if you are looking for an entry point to hold the stock long term, MFI will get you in at a cheaper price...during the stock's trend.
Money Flow Index helps identify two important situations:
Reversal of trend: If your stock’s price is rising while the MFI signal line is falling, smart money is selling or just not buying any more. Why you may ask is the price still rising? That’s because they’re selling their shares to you. The public is temporarily supporting the price before the drop. Smart traders look for divergences between MFI & the price.
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The same is true on the other side. The price is falling but the Money Flow Index is rising. The institutions are quietly buying, hopefully unnoticed.
Confirmation of trend: Ok. You Amazon. That bad boy is headed up. By popping open the MFI chart you can see the strength of accumulation. That might give you the confidence to hold longer or pick up more shares.
Take a look at Ebay. End of August the MFI drops near the 20. The stock price confirms the selling. But hay, it’s Ebay! This is no schlock operation. Traders realize they have an undervalued stock on their hands and accumulation begins.
Check out the beginning of October. The Money Flow Index is dropping but Ebay looks like its consolidating. At about October 18th it looks like it might even go further to the upside. Many traders might look at October and think; it’s just a consolidation base. This baby is taking a rest before the next plateau. But if you looked at the MFI you would know before hand, smart money is selling. MFI is dropping and Ebay is going along with it. It’s time to follow suit.
Consider MFI your “Danger Will Robinson, danger.”
In 1963 Joseph Granville invented a simple way to determine when institutions were accumulating or selling stock. Basically, it adds volume to a cumulative total should the stock close up for the day, and subtracts volume on days it closes down.
The premise is volume precedes price moves. If we hone in on volume, we’ll be ahead of the game with price. The importance of the OBV signal is not tied to some numerical range or how high it goes. The importance is the trend or the slope of the line.
OBV tries to uncover the clandestine art of accumulation by smart money. The strength of a stock’s price move is determined first by volume. If OBV is rising before the price makes any moves, the institutions are accumulating.
When On Balance Volume and the stock price move upwards together, the public is accumulating as well. This is the scenario institutions want.
Smart money purchased their shares before the price appreciated. The stock now hits the radar screens of the media and general public. The shares we buy are coming from the institutions with a premium built in. That doesn’t mean the stock won’t go higher. It just means we're paying more for the shares. Hopefully it'll have more strength left.
And of course the flip side: A falling OBV while the price is still rising indicates the institutions are selling and a price decline may be imminent.
Let’s look at Merrill Lynch. From August into September, OBV tells us there is no major accumulation going on. By mid to late September we have signs of an accumulation breakdown. Maybe word on the street was that Merrill would be facing huge loses. In late October price & volume says it all.
How I might approach this stock in the furure is this: Merrill has ranged from about $70 to about $90 in the past year. Due to events such as huge losses from credit exposure and the retiring....errr...I mean firing of the CEO, Merrill is in the $50's.
Are we looking at an undervalued stock? Wall Street has a short memory. These firms get fined from the SEC, sued in sexual harassment cases and experience huge loses from trades gone badly. Their stocks eventually go up anyway.
By keeping a watch on MFI or OBV we can see when the smart money will be picking up shares again. And believe me, they will.
Like MFI, many times the OBV signal will rise or fall with the stock price. You can use that as confirmation the stock is still under accumulation or distribution. For those times you bump into a chart showing divergence, you may just have a window into “institutions trying to get there first.”
Act accordingly. Join 'em.
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