Fear and Greed Index

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.

The emotions of traders and investors responding to volatility in the financial markets often play a pivotal role in decision-making.

The fear and greed index 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 index aims to identify market trends and show 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. This indicates potential opportunities to buy or sell assets for a profit.

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 U.S. S&P 500 Index plunged to a three-year low in response to the collapse of Lehman Brothers.

Fear & Greed Index Scores

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

1. Market Momentum: 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.
2. Stock Price Strength: 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.
3. Stock Price Breadth: 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.
4. Put and Call Options: 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.
5. Market Volatility: 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.
6. Safe Haven Demand: 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.
7. Junk Bond Demand: 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.

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:

1. Volatility (25%): The index measures the current volatility and maximum drawdowns of Bitcoin and compares it with the average values for the last 30 days and 90 days. An unusual rise in volatility is taken to indicate fear in the market, while lower volatility points to more greed.
2. Market Momentum/Volume (25%): The index measures the current market volume and momentum compared with the previous 30-day and 90-day average values. High buying volumes in a positive market signal a bullish market, whereas lower volumes indicate fear.
3. Social Media (15%): The index includes an analysis of interactions on X (previously Twitter) to check their speed and volume. An unusually high rate of interaction points to growing public interest and greedy behavior as speculation increases. Lower interaction rates typically indicate the market has grown more fearful.
4. Surveys (15%): Using public polling platform strawpoll.com, Alternative.me conducts weekly polls asking respondents how they see the crypto market. This indicates sentiment among crypto investors.
5. Dominance (10%): The dominance of a cryptocurrency coin or token resembles its market capitalization as a share of the whole market. A rise in Bitcoin dominance tends to be driven by fear of speculative alternatives, or altcoins, as Bitcoin is considered the safe haven of the crypto market. When Bitcoin dominance declines, investors tend to become greedy by investing in riskier, more speculative altcoins in an attempt to profit from the next bull run.
6. Trends (10%): The index pulls data from Google Trends for various Bitcoin-related search queries. For instance, a rise in searches for terms such as “Bitcoin price manipulation” indicates growing fear in the market.

Importance of the Fear and Greed Index

A fear and greed index is a useful sentiment indicator for investors and traders. Understanding market sentiment can help to make informed decisions on when to open and close positions.

For instance, when an index signals extreme fear, there may be potential buying opportunities as assets can become oversold and subsequently revert to the mean.

When an index signals extreme greed, the market could be overbought and approaching a market top ahead of a selloff.

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.

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.

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.