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Chaikin Money Flow Technical Indicator Explained

Introduction

Technical analysis of individual stocks must include volume studies in order to provide a true picture of the internal dynamics of a stock. Most technical indicators focus on price alone or force the trader into looking at price and raw volume to try to figure out relationships which can predict future price action.

Analyzing a stock’s price action without using an effective volume indicator is like predicting how far a car will travel based only on how fast it is going. Without knowing how much gas is left in the tank you can’t know how far a car can go.

Volume is the fuel which powers stock price movement.

Much has been written over the years about volume starting with Gartley in the 1930’s and carried forward by Joe Granville, David Bostian and Larry Williams. The reality about volume patterns can be boiled down into one sentence…price follows volume.

A good and sustainable advance in price must be accompanied by rising volume. New highs in price on lower volume hint at a price reversal. Conversely, significant new lows in price are usually accompanied by a sharp rise in volume followed by a rally and a lower volume retest of those lows. This is the classic W bottom pattern.

But as with most things in life the devil is in the details. The same is true in volume analysis of stocks. What an indicator measures and how it approaches volume patterns and most important, how you interpret that indicator shape the end result.

Chaikin Money Flow

I developed the Chaikin Money Flow technical indicator to measure the flow of funds into and out of a stock over a one month time period. Each day’s trading pattern is analyzed to arrive at a net accumulation/distribution number. The key to the value of this approach is the observation that strong stocks tend to close in the upper portion of their range, day in and day out, and on rising volume.

This represents the reality that fundamentals such as earnings surprise and earnings estimate revisions are the true drivers of stock price movement on a daily basis. When a company reports a positive earnings surprise or increases their guidance to analysts about future earnings, a round of follow the leader begins with securities analysts raising their quarterly and full year earnings estimates one after another. This results in increasing demand for a stock which in an up market results in the sellers being satisfied early in the trading session and pent up demand for shares later in the day.

Of course the market plays a role here so that on very weak days even strong stocks will close in the lower half of their range. That’s why Chaikin Money Flow measures the volume accumulation over a 21 day period.

How is it Computed?

The following is the formula for the Chaikin Money Flow Indicator:

Step 1 ((Close – Low) – (High – Close)/ (High – Low)) * Volume

Step 2 21 Day Average of Step1 (Daily MF) / 21 Day Average of Volume

In plain English we are computing a one day net positive or negative money flow based on whether a stock closes above or below its’ mid-point for the day, measuring how close to its’ high or low it is at the close, and then relating that to the volume.

By taking a 21 day average of the daily money flow and dividing that by the 21 day average volume we now have the Chaikin Money Flow Oscillator which has boundaries between + 1 and - 1 or + 100 and -100 depending on the software program.

What are the Unique Characteristics of CMF?

Strong stocks such as ARG, MA and MCD will show positive readings of CMF (Green in displays which use color to differentiate positive and negative readings) for months on end. Positive CMF readings greater than 20 indicate powerful accumulation and further upside price action. Even after price corrections of 5 – 10 days the CMF will stay green or positive. The more normal relationship is for the CMF to fluctuate around zero by rising and falling with price. Finding stocks with bullish CMF patterns, or bearish ones to sell or buy puts on is a very visual process, and one that is easy to be good at.

Weak stocks such as GMCR, GS, NFLX and OPEN will have just the opposite patterns: negative or Red CMF readings month in and month out.

While it is possible to use cross overs above and below the zero line as signals, these tend to be confirming signals rather than action oriented ones. However, on a weekly chart a reversal from an overbought or oversold extreme followed by a cross below or above the zero is a very powerful signal.

Persistency of Money Flow

The percentage of days in an intermediate 126 day (6 month) time window that the CMF is above zero (green) is known as persistency of money flow. Finding stocks with a high persistency of money flow, when combined with strong relative strength to the market, is a powerful way to identify the biggest potential winners going forward. Investor’s Business Daily thought so much of this concept that they created their Accumulation/Distribution Indicator using a 65 day persistency of CMF.

Using short term sell-offs to a rising 21 day moving average in a well-defined uptrend or to a lower volatility band in a downtrend in combination, with stocks which exhibit strong persistency of CMF and positive relative strength is a proven method for generating stock market profits on both the long and the short side.

Option strategies which are built around this approach have a much higher chance to succeed.

Example of Strong Chaikin Money Flow

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Example of Weak Chaikin Money Flow

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