The typical indicators used by technicians include tests of price (head and shoulders, double tops or bottoms, gapping price action, triangles, moving averages), combined with reversal indicators found in candlesticks. These are all valuable as far as price trends are concerned; however, limited your analysis to just price movement misses some reversals. A chronic technical problem is that reversals often are not spotted until after they occur. You need to see where momentum is heading rather where it has been.
For example, a popular technique is to time entry or exit on crossover between two moving averages. A study of charts shows, though, that when crossover takes place, it is normally after the reversal. Often, crossover takes place way too late to time trades to maximum advantage. This is where CMF is valuable as an early indicator of changing momentum and reversal likely to occur a few sessions later rather than only confirming reversal a few sessions earlier than the current price trend.
Background of CMF
The Chaikin Money Flow indicator was the brainchild of Marc Chaikin, owner of Chaikin Capital, LLC based in Connecticut. With experience over decades in trading stocks, options and futures, Chaikin observed a common problem for traders: Is a particular stock currently in an accumulation or a distribution phase? This seems simple. Are traders buying or selling or, more to the point, are buyers or sellers in command of price movement at the moment? This is not as easy to spot as most traders would like. Chaikin developed his first widely-used indicator, the Accumulation/Distribution (A/D) formula. This summarizes supply and demand pressure on current price and the momentum within that trend. Accordingly, it is described as a momentum oscillator. It identifies levels of control among sellers or buyers over a series of trading days based on volume flow. The formula:
[ ( close - low ) - ( high - close) ] / ( high - low) = A/D
The outcome of this formula produces a value between -1.0 and +1.0. The positive side indicates that buyers were in command in the session’s trading; and a negative outcome tells you that sellers were determining price momentum. However, A/D is only useful for a single day’s action. Applying this over a period of time is the more revealing concept, and this is where CMF was developed. CMF not only tells you which side of the trade is stronger, but also reveals the growing or ebbing momentum involved. This is where traders benefit from observing CMF along with other technical signals.
CMF is an expanded study of A/D. It consists of A/D over a series of trading sessions, divided by volume for the same time period. Free online charting services compute this for you instantly and adjust charts to reflect CMF for any period and for any trading increment (for example, daily, hourly, or 15-minute charts). The calculation is most often based on the most recent 21 trading sessions. The formula:
A/D(21) / Volume(21)
CMF compared to breadth analysis
CMF is a great indicator when coupled with breadth analysis. This is a study of the trend in price volatility over a period of time. A trading range, by itself, is only one indicator of volatility; but does price move very little within that range, or does it gyrate wildly from resistance to support, and then back again? How wide is the breadth in terms of price points? Is the range gradually expanding or contracting?
All of these analytical points reveal a lot about how price behaves. However, breadth analysis by itself is only part of the bigger picture. For some traders, as long as price remains within the trading range, that is the whole story. Nothing is significant until a traditional signal testing resistance or support takes place. After this occurs, traders may anticipate breakouts and act. But if you assume that price remaining within the trading range (without any clear technical signals taking place) you may miss an equally important emerging trend: a subtle but significant change in momentum.
CMF, when adding to the traditional technical analysis based on observed trading range, expands your observations by allowing you to recognize developing momentum even before price tests or moves through the established levels of resistance or support. The advantage in adding this to traditional price analysis is that it is easy to add in using free online charting. (For most such services, CMF is one of many elective indicators you can choose. For example www.StockCharts.com allows you to select CMF along with the price summary.)
Because CMF is a simple "value" between -1.0 and +1.0, its significance is easy to track, especially in what it demonstrates over a period of time. For example, in the figure, Ford Motor Company (F) is shown over three months along with its CMF.
Notice that CMF tracks the price direction throughout most of the chart. Price direction is summarized with the trendlines from beginning to end and there are no surprises except that CMF leads the trend by a few sessions as direction reverses. Then in the last week of the chart, a surprising development begins. The price trend is moving upward, but CMF is retreating in the opposite direction. This is exactly the kind of development you seek in using CMF. What does the opposite movement tell you? Is the current price trend going to turn suddenly? Can you confirm the trend or find a different confirmation, that the apparent rally is not going to last?
In this case, note that even though the direction is upward, all four of the latest sessions have gaps in their trading ranges. This gapping trend can mean one of two things: Either price is about to explode to the upside, or price movement is going to reverse and fill those gaps in the immediate future. CMF gives you a valuable piece of insight: Sellers are in command here, meaning the price momentum probably cannot be sustained by more buying. Price is most likely to turn in coming sessions, and fill those gaps. The support in this three-month period, at about $9.75, has not been tested since July, and July 19 seemed to establish a new support level at $11.25 per share. However, the most recent price action fell below that support level for several sessions before the latest rally. Some technicians would define this as a failed breakout below support; but when the repetitive gapping action is combined with the declining CMF momentum, the uptrend is very questionable. As a breadth analysis in this case, Ford has been highly volatile, and any trend has to be viewed with doubt, including the latest one. When you see CMF moving away from price direction, is usually precedes a price reversal.