How to read and use the Chaikin Money Flow trading indicator
Chaikin money flow indicator measures the type of pressure which dominates the market.
What is Chaikin money flow?
Marc Chaikin introduced Chaikin Money Flow indicator (CMF) in the 1980s as a technical indicator which measures the money flow volume during a specific period. The CMF indicator can be used to determine whether there is a buyer's pressure or a seller's pressure on the market. The indicator is based on the idea that when the closing price is close to the high an accumulation is evident, whereas if the closing price is closer to the low, a distribution occurs. The CMF is commonly used to confirm a trend, measure a trend strength or to identify potential trend reversals or breakouts.
The indicator default setting is either 20 or 21 periods and the Chaikin money flow calculation is performed through three steps which are:
- Calculation of the Money Flow Multiplier
Money Flow Multiplier = [(Close price - Low price) - (High price – Close price)] / (High - Low)
- Find the Money flow volume by multiplying the money flow multiplier for each period with the associated volume
Money Flow Volume = Money Flow Multiplier x Volume for the period
- Add the Money Flow Volume for the number of periods considered (the default setup is 20 periods) and divide the value by the 20-period sum of the volume
20-period CMF = 20 Period Sum of Money Flow Volume / 20 Period Sum of Volume
As you can see the Money Flow Volume depends on the value of the multiplier, and the multiplier will have a positive value when the close price is above the high-low midpoint for the period and negative when it is below the midpoint.
Chaikin money flow explained
As an oscillator indicator, the Chaikin Money Flow indicator is available on most trading platforms and it is located below the asset chart as a line which fluctuates around the zero-line. The default setup is for 20 periods, but you have the option to change the number of periods according to your preferences and strategy. The CMF can take values between +1 and – 1, but it should be noted that it does not reach the extreme value often. The area above the centreline or the zero line is considered to be a bullish territory while the area below the line is considered to be a bearish territory. Consequently, when the CMF values are above the zero-line, it will be an indication of the existence of buyer's pressure and it is expected that sellers pressure exists when the indicator values are in the negative area.
When plotted on your trading platform, the CMF indicator looks as shown in the following graph.
You can see that when the CMF line is in the zone marked with the white rectangle, it is considered to show an upward trend, while a CMF line in the red rectangle will indicate a downtrend. Usually, the values of CMF are within the +0.5 to -0.5 interval and it rarely comes to the levels of +1 or -1. Accordingly, it can be stated that:
- When CMF is approaching +1 level, the buying pressure becomes higher;
- When CMF is nearing – 1 the seller's pressure is higher.
Chaikin money flow trading
Chaikin Money Flow crosses are one way in which traders use the indicator to identify potential alerts. They show potential signals by looking for crosses between the CMF line and the centreline. The very basic way to determine a buy signal is when the CMF line crosses above the zero-line while the price continues to move upwards. On the contrary, a sell signal is identified when the Chaikin Money Flow indicator crosses below the zero-line with the price moving in a downward direction.
The downside with the cross signals is that they may be false because the CMF line can cross the zero line for a short moment and cross it back again. Hence, some traders mark the +-0.05 levels, by plotting lines, and enter long positions when the CMF is above the +0.05 level or execute short positions when the CMF is below -0.05 level.
An example of how a CMF crosses signals would look like is presented in the next graph.
Going through the graph, you can notice that the CMF crosses above the zero-line at the point marked with the red circle indicating a potential buy signal. After taking a long position, the price continues to move in an upward direction. The sell crossover is marked with the yellow circle when the trader may decide to take a short position and it can be seen that the price continues to fall. The points in the blue circle serve the purpose of helping you understand why some traders plot the +-0.05 levels, as you can see, at first glance, it looks that there is a crossover the zero-line, but this crossing (if any) is only temporary as the values move back to the bullish zones.
Chaikin Money Flow can be used along with the support and resistance when it can confirm breakouts from these levels. Consequently, if the price breakouts out the resistance level during an upward trend while the CMF exhibits higher highs, it would indicate that the trend will continue its upward direction. On the other hand, in a downward trend, when the price breaks below the support level while the CMF reaches new lows, it will confirm that the downward trend will continue.
A potential trend reversal can be identified through possible divergences when the price action and the CMF move in opposite directions. Bullish divergence may appear when the price moves to a new low while the CMF does not follow the same movement and this is an indication that an upward trend may emerge. On the other hand, a bearish divergence is formed when the price moves to a new high while the CMF remains the same or even falls, indicating the possible beginning of a downward trend.
Although volume traders commonly use CMF, a word of caution would be that it is not particularly reliable as a standalone indicator. Therefore, you should use the indicator in conjunction with other technical analysis indicators to confirm the identified signals.
Advantages of Chaikin money flow indicator
- A useful indicator during trending markets;
- A useful tool for confirming trend direction;
- Can provide potential exit signals when there is potential for a trend reversal.
Drawbacks of Chaikin money flow indicator
- It should not be used as a standalone indicator;
- Traders cannot determine potential stop-loss and take-profit points;
- Can provide false signals during range-bound market conditions as the values can fluctuate around the zero-line;
- It would be better not to be used on smaller time frames.
FURTHER READING: How to read and use the Williams %R trading indicator
FURTHER READING: How to read and use the average directional index indicator