What Is the Liquidity Indicator?

The Money Flow Index (MFI) is a momentum indicator that measures trading volume in the stock market. The liquidity indicator points to the direction that money is flowing, either toward selling or toward buying. Related reading: ATR Indicator.

The indicator is measured on a scale from 20 to 80. A reading of 20 is the lowest level and signals selling exhaustion, meaning the flow of liquidity is about to turn toward buying. A reading of 80, the highest level, signals buying exhaustion and a shift in the flow of liquidity toward selling.

The liquidity indicator is one of the most widely used tools in the stock market and on trading platforms. This popular indicator tells traders when the market has reached an extreme, whether in selling or buying.

More: 7 things you should know about financial indicators

How does the MFI liquidity indicator work?

This indicator measures the momentum of money flowing into and out of a stock, which helps traders in the stock market know when liquidity is entering or leaving a stock. As a result, when trading volumes and prices rise, the stock price rises, and the opposite is also true.

What is the trading strategy for the liquidity indicator?

During periods of peak buying and selling in the market, you also need to look at how the MFI behaves relative to price. That’s because a divergence between the two can be very significant.

In other words, you’re looking for moments when price tells one story but the liquidity indicator doesn’t follow along and tells a different one instead. For example, if price is hitting new record highs while the liquidity indicator fails to hit new record highs, or even drops.

This is considered a bearish divergence and can be used as a sell signal. Conversely, if price has hit new lows but the MFI fails to set new lows, or rises instead, that would be a bullish divergence in the liquidity indicator.

This means that:

Bearish divergence: occurs in the liquidity indicator when price reaches new record highs while the liquidity volume indicator does not reach new record highs, or even falls. It can be used as a sell signal.

Bullish divergence: occurs in the liquidity indicator if price reaches new lows, but the liquidity volume indicator fails to set new lows, or rises instead. It can be used as a buy signal.

Learn about the risks of excess or shortage of liquidity for companies:

• First: the purpose of cash financial planning – is it meant to achieve long-term plans (3–5 years), medium-term plans (1–3 years), or short-term plans.
• Second: defining the company’s operating strategy – whether it is an offensive strategy, since it brings a good new product to the market and thereby controls the market, in addition to its ability to bear risk and its search for new opportunities to seize with a high degree of confidence, which allows it to adopt a strategy of diversification, restructuring, expansion, or merger.
• Or whether it adopts a defensive strategy, because it faces many environmental threats and cannot control the conditions around it, and the products it makes cannot compete in the market.
• It may also have no opportunities for success, development, or improvement, leaving it no choice but to move toward liquidation and consolidation, focus on the customers of certain products only, stop selling certain products, and close some production lines – after it has settled on the strategy it will follow.

Below, we look at its financial capacity:

The liquidity indicator shows the extent to which a company’s current assets, in their various forms, cover its short-term obligations. It therefore shows how many times the company is able to settle its current obligations by converting current assets into cash. The liquidity indicator assesses the company’s short-term financial position and its ability to raise capital (short-term, long-term, loans, equity) through the following:

• How diversified its resources are for achieving future liquidity.
• The cost of its capital compared with other competitors.
• Its relationship with investors, lenders, and shareholders.
• How effective its financial systems are for controlling cost.
• How efficient and effective its applied accounting systems are.
• The size of its working capital and how flexible it is given its components.
• The quality of its inventory controls.
• The amount of liquidity it needs to operate.
• The value of its long-term and short-term obligations.
• The size of cash flows from operations.
• The size of cash flows from investing.
• The size of cash flows from financing.

As a result, any company can plan the optimal model for managing and planning its liquidity.

Take, for example, the Miller–Orr Model

This works by setting a maximum and minimum requirement for funds under the Control Limit Method, where a maximum and minimum cash level is set so that whenever the balance hits its maximum, management directs the surplus cash down to the minimum, keeping the cash balance always within the range between the maximum (Max) and the minimum (Min) – or it may suit the company to use a different model based on the data available to it.

The Basel Committee set out in its decisions numerous advanced banking supervision requirements for controlling banking risks, in line with the general principles of risk management, which include:

• Assessing Risks.
• Controlling Risk Exposures.
• Monitoring Risks.

First: setting minimum limits for capital adequacy:

This is aimed at showing the bank’s ability to control risk and absorb losses.

Second: guiding procedures for granting credit:

Evaluating the bank’s policies and practices for managing its asset portfolios, and its procedures for granting credit and investment based on sound foundations and rules, is a successful standard that reflects sound credit decisions.

Third: controls for limiting credit concentrations:

An adequate information system is needed to limit concentration risks, one that highlights the most important features of concentration in every activity and the real limits for these levels, capable of preventing any losses.

Fourth: controls for limiting lending risk in the liquidity indicator:

This involves applying the same protective terms and procedures used in general lending cases to related parties, in order to guard against risks arising from leniency or discriminatory treatment of these customers.

Fifth: controls for limiting market risk:

This requires applying systems that measure market risk precisely and carefully and control it efficiently, along with the need for quantitative and qualitative standards for managing that risk.

Sixth: controls for limiting interest rate risk:

This includes having a system, procedures, and measures in place to monitor fluctuations in the interest rate.

Seventh: controls for limiting liquidity risk:

This involves confirming the bank’s ability to meet all its contractual obligations in a way that preserves the required level of liquidity.

Eighth: controls for limiting operational risk:

This involves banks putting in place adequate policies for managing operational risk so as to cover all the main operating systems within the bank.

Ninth: controls for limiting fraud risk:

It must be confirmed that there is a complete framework of controls against any behavior, loss of confidence, or weakness in internal controls that could lead to fraud.

What is the effect of the liquidity indicator on financial leverage?

• One of the advantages of financial leverage in the liquidity indicator is that it improves a firm’s financial performance, since raising the leverage ratio, given a return on borrowed funds above their cost, inevitably increases profits.
• Financing also creates a tax benefit, because the cost of borrowing is treated as a tax-deductible expense against taxable profits. When this cost is lower, deducting less than the cost of equity makes external debt financing a more attractive funding source than other sources.
• At the same time, relying on increased loans without using them efficiently exposes the firm to risk if the cost of these funds rises above the expected return on the investment.
• Financial performance depends on the firm’s ability to reach the optimal capital structure mix by choosing between equity financing and borrowing, with the goal of balancing risk and return or profit – which lowers financing costs and raises profit rates.
• External financing amplifies equity by increasing the return on the firm’s funds when it invests them at a return greater than their cost, by capturing the prevailing market return.
• At the same time, relying on borrowing as a source of financing can lead to a loss if the return on the borrowed funds falls below their cost.
• For this reason, firms’ financing decisions are critical and difficult; they require precision and a balance between internal and external financing, weighing debt financing against equity financing.

What are the trading risks during periods of falling liquidity?

• Around the release of economic news, especially central banks’ key interest rates, inflation figures, business activity indicators, and GDP data, as well as speeches by the heads of the Bank of England, the Bank of Japan, the Swiss National Bank, and the U.S. Federal Reserve.
• During rollover periods (23:55–00:05 EET), when major banks and ECN systems stop providing quotes and step away, pulling their orders from the system.
• Before or during a drop in activity during a given instrument’s trading session, since currencies behave differently across different trading sessions.

For example, the yen trades actively during the Asian session, the euro during the European session, and so on.

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FAQ

What is a forex indicator?

It’s a technical indicator used to analyze price movement in forex markets to forecast rises and falls using mathematical tools that analyze and study the numbers.

What are the best technical indicators?

There are many technical indicators used to analyze the forex market, and among the best are the Stochastic indicator and Bollinger Bands.

What is the MFI indicator?

The Money Flow Index (MFI) is a technical tool traders use to track money by measuring it flowing into and out of a security over a specific period, in order to see whether there is buying or selling pressure.

How do you trade with the MFI indicator?

Price changes are analyzed through the MFI indicator by determining whether the flow is positive or negative. The Money Flow Index ranges between 0 and 100, with oversold conditions at readings below 20 and overbought conditions at readings above 80.

What is the cash flow indicator?

It’s an indicator for calculating debt and liquidity, calculated by taking total debt and dividing it by the minimum monthly payment. Debt with a low cash flow indicator is considered ineffective and should be paid off first.

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