A common strategy traders implement to measure cash flow is to enter or exit trades in accordance with the levels of overbought and oversold readings provided by the indicator. Indicator cash flow is calculated using the prices and volumes in an attempt to give the trader a more accurate assessment of the market dynamics than the price or volume separately. It averages the high, low and closing prices and then multiply this figure by the volume of trading.
By calculating each trading day with an average price greater than the price of the previous day, together with the calculation of each trading day the average price is lower than the previous day, cash flow is designed to measure accumulation and distribution. As a Momentum indicator, money flow is used to indicate the conditions of overbought and oversold in the share price. Readings above 80 indicate overbought conditions, while readings below 20 indicate oversold.
Because the money flow indicator is one of the most reliable indicators of overbought / oversold—perhaps partly because it uses higher readings of 80 and 20 compared with the relative strength index are overbought/oversold readings of 70 and 30 traders often tend to buy and sell shares in accordance with the movement of the indicator.
For example, a stock trader initiates a new buy position when the indicator of the cash flow drops to 20 or lower, then holds the stock until then, until the indicator cash flow is approaching a reading of 80. At this point, the trader may simply take profit on his or her position on the purchase and wait for another opportunity to buy at a lower price or choose to not only liquidate his or her long positions and begin to sell the position which looks to take profits when the indicator reading is coming close to the oversold level of 20 years.
As with any overbought/oversold indicator, there is a risk that the market can move significantly 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 increased cash flow.
(For associated reading, see: Basics of cash flow.)