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What is the Fear and Greed Index?
Fear and greed are two of the most powerful emotions that can drive market sentiment and influence investor behavior. To help gauge and understand these sentiments, analysts, traders, and investors use a tool known as the fear and greed index.
The index is designed to measure sentiment and provide insights that can help guide investment decisions. Extreme readings are the most helpful toward making a buy or sell decision on an investment.
The emotions of traders and investors responding to volatility in the financial markets often play a pivotal role in decision-making.
Techopedia Explains the Fear and Greed Index Meaning
The fear and greed index definition was created by CNN Business to quantify this aspect of market psychology and provide investors with a quick and easy way to gauge whether the market is currently driven by fear or greed.
The CNN Fear and Greed Index is a market sentiment indicator that measures the degree of fear or greed among investors on a scale of zero to one hundred.
The scale is based on seven market indicators, such as stock price momentum and market volatility (more on these below).
The index scales from 0 to 100, where lower values signify fear, suggesting a potential buying opportunity and higher values indicate greed, which might signal a market top.
How the Fear and Greed Index Works
The index aims to show the sentiment of stock market participants is particularly relevant to the US stock market and is often considered in relation to major US indices like the S&P 500.
Sentiment is another way to gauge whether stocks are priced fairly, based on the idea that:
- Excessive fear drives share prices down to become underpriced and;
- Excessive greed pushes up stocks to become overvalued.
Both of these extreme conditions indicate potential opportunities to buy or sell assets for a profit.
While it does not track the S&P 500 exclusively, many of the components and indicators used to calculate the index are influenced by movements within large indices like the S&P 500. Consequently, the Fear and Greed Index can provide insights into the overall investor sentiment affecting major US equity markets.
S&P 500 vs. Fear and Greed Index (2016-2021)
The above chart shows the Fear and Greed index plotted as an oscillator underneath the price of the S&P 500. It can be seen that most major market declines are preceded by extreme greed readings. Importantly though, not every extremely greedy reading leads to a major decline.
The Fear & Greed Index tends to be a reliable market indicator. For instance, it dropped to a low of 12 – representing extreme fear – in September 2008, when the S&P 500 Index plunged to a three-year low in response to the collapse of Lehman Brothers.
Factors Influencing Fear and Greed Index
Below, we discuss the specific measurements that make up the fear and greed index formula, but it’s important to understand the underlying factors that cause changes in those measurements and, ultimately, the index to move one way or another.
The Fear and Greed Index is influenced by underlying factors reflecting broader economic and market sentiments:
Fear, Greed, and Money Printing
Especially in the era since the 2008 financial crisis, central banks and ‘money printing’ have significantly influenced investor sentiment, affecting the Fear and Greed Index. Low interest rates and quantitative easing typically push investors toward riskier assets, seeking higher returns, which tends to increase market greed. Conversely, tightening monetary policy or fears of inflation can drive investors toward safer assets, reflecting increased market fear.
Central banks have now become so influential on market sentiment that there is now what’s referred to currently as the ‘Powell Put’ after Fed Chair Jerome Powell and formerly the ‘Yellen Put’ named after Janet Yellen, former Fed Chair and current US Treasury Secretary.
A put option is used by options traders to take a bearish bet on financial markets. The idea of the ‘central banker put’ is that as soon as stock markets fall by enough, the Federal Reserve – as well as the other dominant central banks like the European Central Bank (ECB), Bank of England, and Bank of Japan will step in to save the day and prevent any further declines.
Naturally, if investors believe they will be rescued from any losses, they will act more irrationally (and greedily) than might have done if they were forced to realize the consequence of their actions.
Fear & Greed Index Scores
| Score | Sentiment |
| 0 to 24 | Extreme Fear |
| 25 to 44 | Fear |
| 45 to 55 | Neutral |
| 56 to 75 | Greed |
| 76 to 100 | Extreme Greed |
The index takes into account a combination of seven factors, including market volatility, trading volume, and investor sentiment, which are equally weighted to calculate a single numerical value plotted on a scale ranging from 0 to 100.
Lower values indicate extreme fear, or bearishness, in the market, and higher values suggest a bullish market characterized by excessive greed, with 0 representing maximum fear and 100 indicating maximum greediness.
The index tracks how much these individual indicators deviate from their averages compared to how much they normally diverge.
The index gives each indicator equal weighting in calculating a score from 0 to 100, with 100 representing maximum greediness and 0 signaling maximum fear.
7 Key Components of the Fear and Greed Index
Momentum-based trading indicators, such as the relative strength index (RSI) and moving averages, are included to assess the overall direction of the market. Strong upward momentum can signal greed, pushing up the index, whereas slowing momentum can signal growing fear and a lower index value.
The index measures the number of stocks on the New York Stock Exchange (NYSE) at 52-week highs compared to those at 52-week lows. When there are many more highs than lows, it signals bullish sentiment. More lows than highs point to a bearish sentiment.
The index looks at the number of shares on the NYSE that are rising in price compared to the number that are falling. A rising number indicates greed, while a decreasing number signals fear.
Options are contracts that give traders the right to buy or sell securities at a specified price on a set date. Calls are the option to buy, and puts are the option to sell, so when the ratio of puts to calls rises about 1, it typically signals that investors are growing more fearful. A higher ratio of calls to puts signals bullish sentiment.
The standard measure of market volatility is the CBOE Volatility Index, known as the VIX. The VIX measures expected price fluctuations in options for the US S&P 500 Index over the next 30 days. The VIX tends to be lower when the market is bullish, signaling greed, whereas increasing market volatility signals rising fear.
Investors look for safe havens during times of heightened volatility when there is more fear in the market. The index measures the difference between Treasury bond and stock returns over the past 20 trading days, as bonds tend to perform better when investors are scared as they are less risky than stocks.
As junk bonds carry a higher risk of default than other bonds, a smaller difference between yields for junk bonds and government bonds, which are typically safer, signals that there is more greed in the market and investors are taking on more risk. Conversely, a bigger difference in yields signals greater fear.
How is the Fear and Greed Index Сalculated?
The seven sentiment indicators used to make up the fear and greed index are normalized to create a 100 score, and the index is the average of these normalized scores.
In a hypothetical calculation process for the Fear and Greed Index:
- Assume the S&P 500 is 10% above its 125-day moving average.
- There are 300 new 52-week highs and only 50 new 52-week lows on the NYSE.
- Advancing volume is triple the declining volume in the stock market.
- The VIX is unusually low at 12, suggesting low market fear.
- The performance ratio of stocks to bonds is significantly high, indicating a preference for stocks.
- The volume of call options is double the volume of put options.
- The spread between junk bonds and Treasury yields is tighter than usual, indicating higher demand for riskier bonds.
For example, say the average among these conditions is at the 90th percentile of their historical observations, they would score a 90, which suggests high market greed by historical standards.
Using the Fear and Greed Index in Investment Strategies
The best way to use the fear and greed indicator is in the context of contrarian investing.
Contrarian investors look to go against the crowd when its emotional state gets extreme, i.e., extreme greed or extreme fear. This is based on the belief that the crowd tends to be overly bullish or bearish at market turning points.
To effectively interpret market trends using the Fear and Greed Index, you can follow these structured steps, incorporating checks for additional confirmation to make informed decisions:
Steps for Investing with the Fear and Greed Index
Specific Rules for Decision Making
- Avoid Knee-Jerk Reactions
- Confirm with Additional Indicators
- Patience at Market Bottoms
- Take Swift Reaction at Market Tops
Cryptocurrency Fear and Greed Index
Alternative.me, which provides listings of software alternatives, created a cryptocurrency-specific fear and greed index that tracks market sentiment for Bitcoin and other major cryptocurrencies, which can be just as emotional – if not more – than traditional financial markets.
The index analyzes six factors daily to gauge Bitcoin sentiment as representative of the wider crypto market:
Pros and Cons of the Fear and Greed Index
There is a right time and a place to use this index based on its inherent advantages and disadvantages.
Pros
- Comprehensive view: The index aggregates multiple data sources, offering a comprehensive view of market sentiment.
- Identification of opportunities: It helps investors identify potential buying or selling opportunities by highlighting extremes in market sentiment.
- Intuitive interpretation: The index is intuitive and easy to interpret, making it accessible to both professional investors and the general public.
- Daily updates: It offers timely insights into market dynamics and helps investors react promptly to changes in market sentiment.
Cons
- Risk of sole reliance: It does not account for all market nuances or individual investment goals.
- Misleading signals: The indicator can remain at extreme levels for extended periods, potentially leading to misleading signals if not corroborated with other data.
- Lack of historical context: Understanding what constitutes extreme fear or greed levels often requires historical context, which the index alone does not provide.
- Reflective nature: The index is more reflective of current or past conditions rather than predictive of future market movements, limiting its utility for forward-looking investors.
Limitations of Fear and Greed Index
Sentiment, while a useful indicator, should not be the sole basis for investment decisions. Relying solely on sentiment risks reacting to emotional market extremes that may not align with underlying economic or corporate fundamentals.
Sentiment can be an early warning system, indicating when investors are perhaps too bullish or bearish, but it’s essential to seek confirmation through additional indicators. Price action, fundamental analysis, or significant news should corroborate sentiment signals that suggest conditions are ripe for a turnaround, be it a top or a bottom in the market.
The Bottom Line
The fear and greed index is a useful investing tool for gauging market sentiment. It provides investors with insights into whether fear or greed is dominating the financial markets at a given time.
Investors can use such an index as a tool to manage risk and make strategic investment decisions. However, it is essential to consider other analyses and data rather than relying on the index alone, as financial markets can be unpredictable, and sentiment can change rapidly. A well-rounded approach to investing incorporates fundamental and technical analysis alongside sentiment indicators like the fear and greed index.
CNN Business developed the fear and greed index to gauge stock market sentiment. Subsequently, Alternative.me created an index to reflect cryptocurrency market sentiment.
By understanding and interpreting index values, investors can make more informed decisions about buying, selling, or holding assets. It is important to remember, though, that you should use more than one indicator as the basis for investment decisions.
References
- Cboe Global Markets (Cboe)
