A common strategy stock traders implement with the money flow indicator is to enter or exit trades according to the overbought or oversold readings provided by the indicator. The money flow indicator is calculated using price and volume in an attempt to give a trader a more accurate assessment of market momentum than either price or volume separately. It averages the high, low and close prices, then multiplies that figure by the trading volume.
By calculating each trading day with an average price greater than the previous day's price, along with calculating each trading day with an average price lower than the previous day, the money flow aims to measure accumulation and distribution. As a momentum indicator, the money flow is used to indicate overbought or oversold conditions in a stock's price. Readings above 80 indicate overbought conditions, and readings below 20 indicate oversold conditions.
Because the money flow indicator is one of the more reliable indicators of overbought and oversold conditions – perhaps partly because it uses the higher readings of 80 and 20, as compared to the relative strength index's overbought/oversold readings of 70 and 30 – traders commonly seek to buy and sell a stock in accordance with the movement of the indicator.
For example, a stock trader initiates a new buy position when the money flow indicator drops to a reading of 20 or lower, then holds the stock until the money flow indicator nears a reading of 80. At that point, the trader may simply take profit on his or her buy position and wait for another buying opportunity at a lower price or choose to not only liquidate his or her long position but initiate a short-selling position that looks to take profit when the indicator approaches readings near the oversold level of 20.
As with any overbought/oversold indicator, there is a risk the market may move substantially higher or lower than the price at which the indicator shows the market as being overextended. For this reason, traders often use other indicators to complement the money flow indicator.
(For related reading, see "The Basics of Money Flow.")