Fear and greed are influential emotions in the investment world that can considerably affect share prices, volume, direction, and volatility. These emotions inspired Cable News Network (CNN) Money to create a metric to gauge and track the day-to-day sentiments of stock traders. Known as the Fear and Greed Index (FGI), the indicator gauges how investors across the whole stock market feel at a given time.
The index is an important component that can measure if the market is bearish or bullish. It is based on the assumption that fear and greed affect investment behavior, with investors buying shares when they want greater profits and selling them when they are scared.
The index can work as a tool to make sound investments. Several factors come into play that weighs differently. All in all, you have a number on a scale of 0 (fear) to 100 (greed), where 50 is regarded as neutral through tracking market price variations on a daily, weekly, monthly, and annual basis.
Below we shall discuss more closely how the Fear and Greed Index is calculated, as well as how investors can use it to make better investment decisions.
Fear and Greed Index Further Explained
Fear is the investor sentiment that drives them to leave the stock market in panic when it is bearish, whereas greed can have the reverse effect. Investors may buy shares at a price not their worth if they’re feeling greedy. When these market sentiments change from greed to fear or vice versa, it may predict a shift in the market’s direction. The logic of the greed fear index is that:
- Excessive greed can lead to overvalued or overbought stocks that may trigger mass selling.
- Excessive fear can result in undervalued or oversold stocks, which indicates buying.
Thus, the Fear and Greed Index is considered a contrarian tool that gauges the fear and greed level in the market, enabling investors to sell when others get too greedy or buy when everyone is fearful.
This way, investors can manage the risks and make adequate allocation decisions by understanding the current market sentiment, which is the emotion that drives the stock market at any given time. For instance:
- When the sentiment is bearish, the stocks follow a downward trend, and investors may want to minimize risk by increasing their allocation of cash.
- When the sentiment is bullish, the stocks start recovering, and investors might want to enhance their allocation towards equities.
However, this isn’t as clear as it appears because the best buying opportunities usually appear when prices are touching their peak, and the best buying opportunities present when prices are quite low.
Some conscious restrictions must be established to make sure that greed and fear situations do not influence investment decisions, such as:
- Developing and following a trading strategy
- Setting a specified amount for trading on a daily, monthly, weekly, or annual basis
- Fixing the count of trades and adhering to it in order to avoid greed
- Having positive thinking toward failures
- Controlling anxiety in order to avoid investing in a more serious deal
As mentioned above, FGI offers awareness about whether the stock market is overvalued or undervalued. Since FOMO (fear of missing out) indicates a buying signal and vice versa, this tool protects investors from making sentimental decisions.
Calculating Fear and Greed Index
CNNMoney measures seven different factors (indicators) on a scale of 0-100 and weights them equally to generate FGI value. The number 50 is considered neutral, while anything higher indicates more greed than usual. These factors are:
- Stock Price Strength
This factor examines the New York Stock Exchange (NYSE) and compares the number of stocks on the NYSE hitting 52 week highs with those all-time lows. In case of positive price strength, that is, more companies are reaching higher highs, it comprehends a bullish market (greed) and vice versa.
Just like the CNNMoney Fear and Greed Index, if the index displays extreme fear, i.e., 0 index value, it can indicate worried investors, however, this can be a buying opportunity. On the other hand, if the index shows extreme greed, i.e., a 100 index value, this signifies that the market will undergo a correction.
Market breadth refers to the number of stocks involved in a given index or on a stock market, such as the NYSE or Nasdaq. Positive market breadth happens when a greater number of stocks are rising than are declining.
- Market Momentum
The third factor considers the performance of the Standard & Poor’s (S&P’s) 500 Index and compares it to its 125-day moving average. In the case of the above average performance of the stocks, the market presents a greedy scenario and vice versa.
- Safe-Haven Demand
The next factor on the list computes the difference in the performance of stocks relative to Treasures. When the stock prices go downward, investors accelerate toward buying bonds. This bond over stock preference suggests a weak stock market, indicating fear, and vice versa.
- Put and Call Options
This factor measures the 5-day average of put and call options. Put options permit investors to sell their stocks at or before a specific date at a definite price, while call options work similarly, but the only difference is that investors use them for buying stocks. A lower put/call ratio indicates greed and vice versa.
- Junk Bond Demand
This factor evaluates higher-risk strategies by calculating the spread between yields on investment-grade bonds and junk bonds. A lower yield spread signals a higher junk bond (indicates greed) and vice versa.
- Market Volatility
Here CNN employs the Volatility Index (VIX) from Chicago Board Options Exchange, focusing on a 50-day moving average. VIX assesses the market volatility for the next 30 days. A higher VIX value signals a bearish market (fear) and vice versa.
The Fear and Greed Index for Crypto
With a growing rage for the cryptocurrency market, someone coming up with the idea of the Crypto Fear and Greed Index was certain. Developed by alternate.me, it is updated every eight hours on the website and is based on the premise that the behavior of the crypto market is just as emotional as conventional markets. If the market is bullish, investors can experience FOMO. Moreover, they can often sell their coins in an irrational reaction to witnessing red numbers.
The fear greed index rating for crypto is composed of the following inputs:
- Market volume and momentum (25%)
- Crypto prices volatility of the last 30 and 90 days (25%)
- Social Media hashtags and tweets on Reddit and Twitter (15%)
- Surveys (15%)
- Google trends data (10%)
- Bitcoin dominance (10%)
Similar to the stock market, the crypto market volatility is affected by greed and fear, perhaps a little more, as there aren’t any underlying fundamentals to assess the market. All the investors have to react to the market sentiment, which is mainly driven by emotions, rendering this crypto index a useful tool.
Do’s & Don’ts of Using the Fear and Greed Index
When used appropriately, the Greed and Fear Index works as a guide for profitable buying and selling decisions. Here are some do’s and don’ts of using the index for a profitable investment.
Do’s
- Use it to understand that investing can be sentimental, however, it should not be.
- Use the index to determine the right time to enter the market. For instance, when you have been observing a stock, which becomes further undervalued due to a rise in investor fear, this could be a good buying opportunity.
- Monitor undervalued companies.
Don’ts
- Invest when there is high greed value.
- Use it to establish a short-term gain.
- Do not depend only on this index or other investment sentiment estimators for making investment decisions. Essentials like how speedily companies belonging to your portfolio are increasing earnings and revenues or how much the market economy is growing – are important.
- Abandon a stock swiftly before executing a profit.
Conclusion
Fear and greed are two emotions that have characterized investor sentiment for a long time. The Fear and Greed Index by CNNMoney focuses on quantifying this aspect of market psychology. Investors usually use it for a contrarian view of the market, so they sell when the rest of the herd appears greedy, or if they are fearful, they buy. Although it serves as a helpful tool to decide the right time to trade, it should not be deployed as the only determining factor in trade decisions.
