What is it?
The Chaikin Money Flow (CMF) is an oscillating market strength indicator developed by Marc Chaikin, who became a stockbroker in 1966. To a large extent, the CMF is based on the Accumulation/Distribution (A/D) indicator as it compares the close price and volume of the security with the range (the high and the low) of that security for that same look-back period to determine whether money is flowing in or out of a security during that period. The default look-back period, as suggested by Marc Chaikin, is 21 days. As a general rule, when the CMF indicator rises, it implies that money is starting to flow into the security and when the indicator drops, it implies that money is starting to flow out of the security.
How is it calculated?
The CMF is calculated in four steps. In the first step, the Money Flow Multiplier is calculated for each of the periods that make up the look-back period using the formula:
Money Flow Multiplier = ( ( Close – Low ) – ( High – Close ) ) / ( High - Low )
In the second step, the Money Flow Volume is calculated by multiplying the Volume for each of the periods by the Money Flow Multiplier:
Money Flow Volume = Volume x Money Flow Multiplier
In the third step, the sum of the Money Flow Volume for look-back period is calculated by adding the Money Flow Volume of each constituent period.
Finally, the sum Money Flow Volume for look-back period is divided by the sum of the volume of the look-back period.
The result is a line that oscillates above and below the zero line as it fluctuates between +1 and -1.
How is it used?
As with the Accumulation/Distribution (A/D) line and On Balance Volume (OBV), the direction of the CMF indicates buying or selling strength with a rising CMF indicating increased demand for the underlying security, while a decline in CMF indicating a decline in the demand for the underlying security.
However, the CMF is also an oscillator that oscillates above and below a zero line. Thus, when the CMF crosses up over the zero line, it provides a potential buy signal to go long the market. Conversely, when the CMF crosses down over the zero line, it provides a potential sell signal to go short the market.
As with most other oscillators, divergence can also be applied to the CMF. When the price action of the underlying security forms a higher peak or a lower valley that is not confirmed by a higher peak or a lower valley on CMF, it implies that the current trend on the price action is weakening and a potential reversal is imminent. Thus, when the price of the underlying security makes a lower low while the CMF makes a higher low it indicates that the downtrend is losing momentum and a bullish price reversal is probable. Similarly, when the price of the underlying security makes a higher high while the CMF makes a lower high it indicates that the uptrend is losing momentum and a bearish price reversal is probable.