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Chaikin Money Flow, Part II
by Michael Thomsett

The Chaikin Money Flow (CMF) is most valuable when it is used as a confirming indicator.

Technicians relying on price-specific trends (especially price momentum) will find CMF an exceptionally reliable confirming signal. For example, MA analysis based on trying to anticipate price reversals on convergence and divergence trends gives you insight but -- because moving averages are used -- it can also be tricky, with many false indicators found along the way. You cannot rely 100% on convergence to spot price reversal every time, because momentum within the average itself is constantly shifting. But the combined use of MA analysis and CMF is a powerful cross-confirming method for anticipating price reversals. When you see price averages beginning to converge, implying a coming crossover and reversal, what is CMF doing? How do you time your trade based on MA, which you know can give out false indicators before revealing what is really taking place (often only when it is already too late). However, if you track MA convergence and CMF together, you are more likely to spot and confirm a coming reversal many sessions before other technicians.

This application of two different momentum indicators is in effect the use of two different crossovers. The well-known crossover of MA and proximity to price is well known. The crossover of CMF from positive to negative or vice versa, is equally powerful in telling you in advance how buyer and seller momentum is beginning to shift.

CMF is useful as a confirmation signals for MA. However, remember that like all indicators, CMF can produce a false signal as well. So its confirming attribute has to be kept in perspective. You rely on a general rule of charting that it is unlikely that two completely separate indicators (like MA and CMF) will both give off the same false signal at the same time. It is more likely that a contradictory movement will favor CMF over the apparent price trend, and may be confirmed by MA analysis. Otherwise, when MA and CMF move in the same direction, you can rely on the trend. You may also observe the slowing of momentum through CMF in advance of a turnaround in MA. In some examples, positive CMF will lose strength gradually before turning negative, revealing a long-term weakening in the buyer side, foreshadowing the ending momentum favoring sellers (in spite of the upward price movement in the last week).

CMF and divergence

Convergence of MA is a widely-used momentum indicator; however, CMF is equally valuable as a confirming signal in times of MA divergence. Generally speaking, when CMF contradicts price indicators, the CMF momentum is more reliable and the contradiction itself tells you that the price trend is less than certain. As a divergence indicator or confirming signals, CMF should be compared not only to MA (specifically with the Moving Average Convergence Divergence, or MACD, calculation) but also with the Relative Strength Index (RSI), Stochastic oscillators, and on-balance volume (OBV). All of these are complex calculations of technical momentum, but fortunately all can be automated as add-ons to free charts. Although they are not as apparent as the price trend, they are all strong indicators and should not be overlooked.

Whenever two or more of these oscillators agree (even when the price trend is contrary), it is a reliable indicator of what is likely to occur in price in the near future. This is counter-intuitive for many technicians whose devotion to price analysis often relies on lagging indicators (including price in some instances). These include MA crossover which consistently takes place after the actual reversal.

The real key to any form of technical analysis is to find a signal and then confirm it. No one indicator, even price, should be studied on its own. Confirmation is the essential ingredient that improves your percentages of expertly-timed entry and exit. Confirmation is not always easy to find. The more technical signals you study, the more contradiction you are also going to observe. For this reason, restricting your analysis to price plus one or two strong technical signals (CMF should be high on your list) is going to be the most effective way to improve your timing consistently.

Important questions

Using CMF is more than the immediately level of positive or negative value in the indicator itself. It is the momentum trend that matters. So to use CMF properly, ask yourself a series of questions. First, Is CMF currently positive or negative? This is always the starting point because you need to decide whether buyers or sellers are controlling price. Status and trend work together in CMF, not only because it tells you who is running things, but also because it relates specifically to the price trend.

Second, What is the duration of CMF status? The time that CMF has remained either positive or negative is equally important. The indicator can flirt with the positive/negative line, temporarily moving away from its stronger trend, so the longer it has remained positive or negative, the stringer the indicator.

Third, Which direction is CMF moving right now? Is it remaining steady or trending in one direction or the other? Momentum that is weakening is just as important as a trend as one that is holding steady or strengthening. As the signal moves closer to the zero line (its crossover point), chances increase that a change in direction is about to take place.

Fourth, What other signals are underway in price? Momentum is never going to be found in any signal indicator. Confirmation among two or more trends is an absolute requirement, so technicians are wise to pay attention to all of the indicators they track. For example, you can interpret repetitive gapping action by comparing the price trend to CMF. If CMF had been trending in one direction over more than a month, that strongly favors the CMF direction over price; but in situations like this, it also makes sense to check additional technical indicators to make sure.

About the Author

Michael C. Thomsett is author of Getting Started in Options, Trading with Candlesticks and numerous other books on technical analysis, stock trading and options.

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