It’s like reading tomorrows newspaper today! How many times have you heard that expression describing a market leading indicator or stock trading system? Well, truth be told, there aren’t many that live up to their name and some simply take a great deal of practice to be able to interpret them consistently.
Today though, we are going to talk about a trading indicator that actually does live up to it’s promise and is not so difficult to interpret, at least in part. More on that later. The indicator we are talking about is MFI, or Market Facilitation Index. It was developed by Bill Williams and is really a great indicator for peering beneath the surface of market action.
It is computed by dividing the high price of the day minus the low price of the day by the volume for the day or, (H-L)/V. It is most easily read when displayed as a histogram.
The benefit of this indicator is that it gives insight as to how efficient the price is moving by graphically showing how much volume it took to move the price a given distance, the idea being the less volume it took to move the price, the more efficient it moved. That is not to say a little volume accompanied by a large price move indicates a strong move. The amount of volume is relative to recent trading.
Four basic conditions can be noted from view MFI and volume together.
1) Index is up and volume is up (strong market): This indicates the market is basically moving in one direction and more participants are entering the market. This is an excellent time to already have an open position in the direction the market is moving.
2) Index is down and volume is down (fade): The market idling, usually from fading interest. This usually occurs towards the end of a trend or rally. However, the direction of the next trend or rally could be in either direction.
3) Index up and volume down (fake): The market is moving basically in one direction, but the volume is down due to lack of new participants. Since less volume is moving the price, the activity may be generated primarily on the floor, faking the actual public sentiment.
4) Index down and volume up (squat): The volume is increasing which indicates additional market participants, but the price is not moving as strongly in the same direction. This typically occurs prior to a significant price move in the opposite direction, as the new market participants are those attempting to move the price in a new direction.
We could spend quite a bit of time going over each of the above scenarios, but we’ll focus on number 4, as in my opinion, it is one of the easiest to spot and is very consistent when the conditions are extreme. Take a look at the chart below. The Red indicator is MFI and the blue indicator is volume. You can easily see that during the month of January, while price is on a steady decline, the MFI indicator is also steadily declining while volume is increasing. This is a strong indication of that the market is approaching a turning point, which as you can see in the chart that is does.
Will you always see this pattern before a market turning point? No. You are using these indicators to discern the sentiment behind the market action. Often times market sentiment is mixed and doesn’t give a clear picture with just the days totals. A much clearer picture can be obtained by viewing the individual transactions for the day. The more one sided it becomes however, the more discernable the pattern becomes with end of day data. That is why a clear relationship between MFI and volume is not always apparent, but that is not a problem. If you don’t see a clear indication, move on to another trade or use another method of analysis. As with other indicators, you must try not to “read into it” something that is not there. When a clear relationship is discernable though, this is a great asset to have. It is also a great confirmation tool to use in conjunction with other indicators. With some practice, combinations 1 through 3 can be noted as well.
