Risk reversals reflect the expectation of the market in terms of the direction of an exchange rate. When used in the correct context, risk reversals can be highly useful for generating potentially profitable overbought and oversold signals.

A risk reversal is a combination of a call and a put option on the same currencym withe the same expiry (one month) and the same sensitivity to the underlying exchange rate. They are quoted in terms of the difference in volatility between the call and the put options. Theoretically, these two options should have the same implied volatility, but in practice they often differ, and this difference can be a useful indicator.

If the number is positive, it shows that the market expects the underlying currency to move upwards in price, and that calls are therefore preferred to puts by the market. Similarly, a negative number shows that puts are preferred to calls, and that the market expects the underlying currency to move downwards in price.

Risk reversals are useful in terms of their ability to poll the market, with a positive risk-reversal number implying that the majority of market participants are voting for a rise in the currency rather than a drop. Therefore, they can be used as a tool for evaluating positions on the forex market.

Although the signals that a risk-reversal system generates are not always completely accurate, they can tell you whether the market is bullish or bearish overall. They convey the most information when they have relatively extreme values. An extreme value could be defined as being one standard deviation beyond the averages of positive and negative values. For negative risk-reversal numbers, you are looking for values of one standard deviation below the average, and for positive numbers you are looking for values one standard deviation above the average.

Risk reversals give contrarian signals when they are at these extreme values. This is because when the entire market is positioned for a rise in a certain currency, it makes it harder for that currency to rise, and much more prone to falling as a result of negative news or market events.

A big positive risk-reversal number implies a situation where the currency is overbought, and conversely a big negative risk-reversal number indicates that it is being oversold. While the buy or sell signals that risk reversals are not perfect, they can at least give you some extra information with which to inform your trades.

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When you are performing a technical analysis, you need to focus on various indicators and what they say. Closely analyze the indicators and the bigger picture will be in front of you. Same is the case with the asset trading business. There are many indicators you must consider when trading securities and one of those indicators is the Money Flow Index (MFI).

Money Flow Index

The money flow index is an indicator which shows the strength of money flowing in and out of asset trading. It is interlinked with RSI (Relative Strength Index). The main difference between the two is that RSI only considers prices while money flow index (MFI) takes both price and volume into account. Its range is from 0 to 100.

All the bars whose average price is more than or less than the previous bar are considered while calculating the MFI. Index values are used to plot the money flow. The price and volume nature gives more in-depth information from different angles which could help in determining the progress towards your goal. The money flow index can show lot of fluctuation and highlights overbuying and overselling in an effective way.

Overbought and Oversold

On a scale from 0 to 100, a value of 20 or less is considered oversold and a value of 80 or above is considered overbought. This is also known as accumulation and distribution. It is used to indicate the momentum and direction of the market. You will have to add the distribution and accumulation values of all the trading days and divide it by the number of days you want to find MFI of.

Calculations

Firstly, determine the actual price by using the following formula:

Price = (High + Low + Close)/3

Next, calculate the money flow by following formula:

Raw money flow = Price × Volume

Specify the number of days you are trying to find the money flow for. For example, you want to find money flow for 20 days. Now, it is time to calculate the ratio of money flow by using the following formula:

Money flow ratio = (20 days’ accumulation)/(20 days’ distribution)

Accumulation and distribution can also be replaced with positive and negative money flow respectively in the above formula.

The final step is to find the money flow index. The formula to find the money flow index is:

Money Flow Index = 100 – [100 / (1+Money flow ratio)]

Many traders are looking to take advantage of opportunity when price and money flow index move in opposite directions. This brings about a significant change in the market. Divergence of these two factors, price and money flow index, can be beneficial or can also be disastrous depending on the situation you are in. It is a little risky but if you consider some other factors then you will end up on the safe side.

Other Factors

It would be much better for you if you consider factors other than price and volume because you will be able to see the bigger picture and can easily make the right decision. If there are large gaps in price action, then there is some problem because calculation of money flow is done by taking mid-points of price action into account. If there is a large gap, then it means some mid-points are missing and the complete calculation becomes suspicious and ambiguous.

If the mid-points are missing, the results will be disturbed. It is highly recommended to verify your results through other indicators and don’t depend only on price and money flow. You can also check out exponential moving averages and moving average convergence and divergence which are more accurate as compared to money flow index indicator.

It can give early warning signs for a changing currency trend so you can be prepared beforehand to tackle such issues and save yourself from losses. The STC indicator can also be used but it was primarily developed for the currency trading. The STC indicator reduces the risk of false signals significantly. With computers at your disposal, you can quickly judge the accuracy and reliability of prices thanks to trading software. Be aware of the latest indicators because they might be more efficient as compared to older methods.

Market Place

MKTPlace is a leading digital and social media platform for traders and investors. MKTPlace offers premiere resources for trading and investing education, digital resources for personal finance, news about IoT, AI, Blockchain, Business, market analysis and education resources and guides.