Last Updated on 17 November, 2020 by Samuelsson
Trying to predict what the market might do next is quite difficult, and traders are always looking for ways to predict the direction of the market. A lot of technical indicators have been created, but only a few can give a clue about the activities that move the market as the Chaikin Money Flow Oscillator does.
As you know, price movement is often a result of imbalances in demand and supply. Since price movement is a function of demand and supply, it won’t make sense to analyze price fluctuations without paying attention to demand/supply dynamics, which is why the Chaikin Money Flow oscillator is such a useful indicator in stock trading — it tells you something about the demand/supply by showing the money flow into a security during a specified period.
In this post, you will learn the following:
- What the Chaikin Money Flow oscillator is
- How is the indicator derived?
- How it works
- Its benefits and drawbacks
- How to use it in your trading
What is the Chaikin Money Flow oscillator?
Not to be confused with the Chaikin Oscillator (CO), the Chaikin Money Flow oscillator/indicator (CMF) is a volume-based indicator that tries to measure momentum based on the idea that price follows volume. The indicator was created in the 1980s by an American technical analyst and trader, Marc Chaikin, who is recognized for creating several technical indicators, including the Accumulation Distribution Line (ADL).
The CMF indicator measures the amount of money flow volume over a chosen period, usually 20 or 21 periods. Combining both price and volume data to measure momentum, the indicator can be used to determine whether there is a buying pressure or selling pressure in the market. The idea is that when the closing prices of consecutive trading sessions are near their highs, accumulation is taking place, but if the closing prices are closer to the lows, distribution going on.
The indicator uses the money flow volume, which also forms the basis for the accumulation distribution line (ADL). But instead of getting a cumulative total as it’s done in the ADL, the CMF gets the sum of the money flow volume and divides it with the sum of volume.
The money flow volume is a product of the volume and where the price closed relative to the trading session’s range. It comes from the idea that buying pressure is indicated by a rising volume and the price frequently closing in the upper part of the session’s price range while selling pressure is demonstrated by an increasing volume and the price frequently closing in the lower part of the price range.
In other words, both buying and selling pressures are accompanied by an increase in volume, but the location of the closing prices indicates the predominant force. So the resulting indicator oscillates about the zero line — above zero indicating a bullish trend and below zero implying a bearish trend. Technical analysts and traders use it to weigh the balance of buying or selling pressure. They commonly use it to confirm a trend, measure a trend strength, or to identify potential trend reversals or breakouts. However, is not made to be used as an isolated trading system; it should be used in combination with other trading tools.
How is the Chaikin Money Flow indicator derived?
The Chaikin Money Flow (CMF) oscillator is calculated in three steps as follows:
- Calculating the Money Flow Multiplier, also known as the close location value (CLV), for each period.
- Calculating the Money Flow Volume
- Computing the Chaikin Money Flow
Let’s what is involved in each of those steps.
Step 1: Calculating the Money Flow Multiplier
In this first step, you find the close location value, which is where the price closed relative to the trading session’s range. It is called the Money Flow Multiplier because it shows which direction the money is likely flowing. It is calculated as follows:
Money Flow Multiplier = [(Close – Low) – (High – Close)] / (High – Low)
Step 2: Calculating the Money Flow Volume
You do this by multiplying the value of the Money Flow Multiplier with the period’s volume. Do this for each period. The formula is given as follows:
Money Flow Volume = Money Flow Multiplier x Volume for the Period
Step 3: Computing the Chaikin Money Flow
The Chaikin Money Flow is computed by summing the Money Flow Volume for n periods and dividing the value by the n-period sum of volume. Here is the formula:
n-period CMF = n-period Sum of Money Flow Volume / n-period Sum of Volume
While you can compute the CMF for any period, the usual default period is 20 trading sessions. In this case, n will be 20.
Explaining the numbers
As you can see, each trading session’s Money Flow Volume (and by extension the CMF) depends on the Money Flow Multiplier (close location value). From the formula, we can make these deductions:
- The multiplier is positive when the close price is above the midpoint of the session’s high-low range
- The multiplier is negative when the close is below the midpoint (in the lower half) of the range.
- The multiplier takes a value of +1 when the price close equals the session’s high
- The multiplier takes the value of -1 when the price close equals the session’s low.
- The multiplier has a value of zero if the close is at the midpoint of the range
So the multiplier’s value ranges from +1 to -1, and it adjusts the amount of volume that ends up in Money Flow Volume. Apart from the extremes (+1 or -1), where the volume size remains the same, the multiplier reduces the volume effect in the Money Flow Volume. Since the CMF is gotten from dividing the Money Flow Volume by Volume, it also fluctuates between +1 and -1.
Understanding how the Chaikin Money Flow oscillator works
The CMF indicator is available on most trading platforms, and it is placed in the indicator box of the chart. It can be called an oscillator because the value oscillates between -1 and +1, with 0.00 as the centerline. While some trading platforms may modify the indicator to oscillate between -100 and +100, it is commonly expressed as a decimal. Hence, a value of +51 in one platform may be the same as a value of 0.51 on another; likewise, a value of -7 is the same as -0.07.
Although the CMF fluctuates between -1 and +1 (in theory), it will rarely, if ever, reach those extremes because it would take 20 consecutive closes on the high for the 20-day CMF to reach the +1 value and 20 consecutive closes on the low for it to reach the -1 value. Most of the time, the oscillator fluctuates between -0.50 and +0.50.
The Chaikin Money Flow oscillator can be used to estimate buying and selling pressure over a given period. When the indicator moves above the zero line (positive territory) and climbing higher, it indicates an increasing buying pressure, but when it moves below the zero line (negative territory) and descending, it indicates increased selling pressure.
Traders can use the absolute value of Chaikin Money Flow to confirm or question the price action of the underlying trend. In an up-trending market, the indicator will mostly be in positive values. If the CMF values are negative, the strength of the uptrend may be in question. The opposite is true for a downtrend — the CMF should mostly be in the negative territory, but if it stays in the positive territory, the strength of the downtrend may be in question.
Another important aspect of the CHF oscillator is that there can be a divergence between the indicator and the price swings. Divergence is said to occur when the indicator’s swings don’t match the price swings. When the price makes a higher swing high and the indicator makes a lower swing high (or when the price makes a lower swing high and the indicator makes a higher swing high), there is a bearish divergence, which may indicate distribution and a potential downward reversal. On the flip side, when the price makes a lower swing low and the indicator makes a higher swing low (or when the price makes a higher swing low and the indicator makes a lower swing low), you have a bullish divergence, which may indicate accumulation and a potential upward reversal.
The benefits and drawbacks of the Chaikin Money Flow oscillator
As you can see, the Chaikin Money Flow oscillator can be very helpful to your trading, but it also has its shortcomings. Let’s take a look at some of the benefits and drawbacks of the indicator
The benefits of Chaikin money flow indicator
Here are some of the advantages of using the CMF indicator:
- Spotting a new trending market: The CMF can be used to spot an emerging trend. A rise above the zero line might show an emerging uptrend, while a descent below the zero line might show an emerging downtrend.
- Confirming trend direction and strength: Traders often use the indicator to confirm the trend direction. When the trend is strongly bullish, the CMF stays mostly in the positive territory, and when the trend is strongly bearish, the indicator stays mostly in the negative territory.
- Providing potential exit signals: The CMF indicator can form divergence, which can often tell when there is potential for a trend reversal.
The drawbacks of Chaikin money flow indicator
Here are some of the disadvantages of this indicator:
- Not a trading system: The indicator is not to be used as a standalone indicator; it must be combined with other trading tools.
- Not a trade management tool: While the indicator can sometimes show potential trend reversals, you cannot reliably use it to determine stop-loss and take-profit levels as divergence don’t occur all the time.
- Prone to false signals: The CMF can provide false signals, especially when the market is in a range. False signals are more common in small timeframes, so it would be better not to use it on smaller timeframes.
How to use the Chaikin Money Flow oscillator in your trading
The default setting of the Chaikin Money Flow indicator is 20 or 21 periods, but you can set it to any value that suits you. On the daily chart, the 20/21-day period approximately corresponds to a full trading month’s data, so it may be good enough for a swing trading strategy.
As we stated earlier, the Chaikin Money Flow oscillator should not be traded as a standalone trading system. You have to use it in conjunction with price action patterns or other trading tools/indicators. Some of the tools you can use with this indicator include:
- Trend lines: You can use trend lines to show the direction of the trend, and they also mark potential rising or descending support levels.
- Moving averages: This indicator smoothens the price data and delineates the direction of the trend. Long-period moving averages also serve as dynamic support and resistance levels.
- Support/resistance levels: These are levels where the price had reversed in the past, so the chances of a price reversal around such levels are high.
Now, let’s look at some trades you can use the CMF indicator.
The CMF indicator can be used to trade an upward breakout or a downward breakdown. However, if you are trading stocks, it’s better to only trade upward breakouts, especially if you are a new trader. Here is how you can use the CMF indicator to confirm and trade a breakout:
- Ensure the price has an upward tendency — an upward-sloping moving average or trend line
- Look for a breakout above a known resistance level
- Note the position of the CMF indicator — if the indicator rises above the zero line, the breakout is likely to be genuine
- Go long at the open of the next candlestick
- Place your stop loss below the nearest swing low and put your profit target just before the next resistance level or use a 2:1 reward risk ratio
Trading pullback reversals are one of the most interesting swing trading methods because you are simply trying to capture the impulse swing in the direction of the trend. The CMF oscillator can help in such situations because it can form divergences which are strong signs of reversals. Again, look for buying opportunities only. This is how you use the CMF oscillator for such trades:
- Confirm an uptrend with a trend line or moving average
- Wait for a pullback to the trend line, moving average, or a support level
- Look for a bullish divergence in the CMF oscillator, and if present, go long
- Put your stop loss below the swing low and your profit target before the nearest resistance level
Price action pattern
You can use the CMF indicator to trade some price action chart patterns, such as flags and pennants, triangles, double bottoms, and inverse head and shoulders. The indicator can help you confirm the trade signals from these patterns. This is what you do:
- Spot a developing price action chart pattern
- Attach the CMF indicator on your chart and wait for the pattern to complete
- Check whether the position of the CMF indicator supports the signal from the pattern — the CMF should be in the positive territory to confirm a bullish signal
- Enter a trade and manage accordingly
Trend reversals (exiting a position)
It doesn’t make much sense to go looking for trend reversals because it is very difficult to time the market. But sensing a potential trend reversal is a call to close your position. The CMF oscillator may indicate a potential trend reversal or, at least, a deep pullback if it forms a divergence against your position. When that happens, it may be time to get out of the trade.
The Chaikin Money Flow oscillator is a very useful indicator for technical traders because it can help confirm trends and spot potential reversals. However, it should not be used as a standalone trading system; you need to combine it with other trading tools.