Divergences and Failures

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Failure swings and divergences can be combined to create more robust signals. A bullish failure swing occurs when MFI becomes oversold below 20, surges above 20, holds above 20 on a pullback and then breaks above its prior reaction high. A bullish divergence forms when prices move to a lower low, but the indicator forms a higher low to show improving money flow or momentum.

 

On the Aetna (AET) chart below, a bullish divergence and failure swing formed in January-February 2010. First, notice how the stock formed a lower low in February and MFI held well above its January low for a bullish divergence. Second, notice how MFI dipped below 20 in January, held above 20 in February and broke its prior high in late February. This signal combination foreshadowed a strong advance in March.

 

 A bearish failure swing occurs when MFI becomes overbought above 80, plunges below 80, fails to exceed 80 on a bounce and then breaks below the prior reaction low. A bearish divergence forms when the stock forges a higher high and the indicator forms a lower high, which indicates deteriorating money flow or momentum.

On the Aetna chart above, a bearish divergence and failure swing formed in August-September. The stock moved to a new high in September, but MFI formed a significantly lower high. A bearish failure swing occurred as MFI became overbought above 80 in late August, failed to reach 80 with the September bounce and broke the prior lows with a decline in late September.

 

The Money Flow Index is a rather unique indicator that combines momentum and volume with an RSI formula. RSI momentum generally favors the bulls when the indicator is above 50 and the bears when below 50. Even though MFI is considered a volume-weighted RSI, using the centerline to determine a bullish or bearish bias does not work as well. Instead, MFI is better suited to identify potential reversals with overbought/oversold levels, bullish/bearish divergences and bullish/bearish failure swings. As with all indicators, MFI should not be used by itself. A pure momentum oscillator, such as RSI, or pattern analysis can be combined with MFI to increase signal robustness.

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