The Fear & Greed Index and how to read it

The article on Saakuru Academy about the Fear & Greed Index elaborates on:

1. Its purpose to gauge the market’s emotional sentiment, impacting investment decisions.
2. The index’s reliance on seven factors to evaluate market conditions and sentiment.
3. Application in the cryptocurrency market with a specific fear and greed index.
4. Importance for investors in understanding market dynamics and making informed decisions.

Experienced investors use a number of different tools to help determine their investment strategy. For many, one of those is the Fear & Greed Index, which can be used to assess market sentiment — and specifically how other investors currently feel about stocks.

This can be incredibly useful, since when investors are greedy, they are more inclined to pay higher prices, and when they are fearful, they may avoid buying altogether. In this AAG Academy guide, we’ll look at what the Fear & Greed Index is and how it works, the different factors used to calculate, and how it can be useful.

What is the Fear & Greed Index?

The Fear & Greed Index is a gauge of stock market movements and whether stocks are fairly priced. Originally devised by CNN Money, it is based on the theory that two primary emotions influence how much investors are willing to pay for stocks. Logic dictates that excessive fear tends to drive down share prices, while excessive greed has the opposite effect.

Fear and greed are emotions we’re all familiar with, and many of us experience them on a regular basis — particularly when it comes to investing. That’s true for both inexperienced investors and industry veterans who have been buying and selling stocks for decades. Therefore, it is foolish to assume those emotions would have no impact on stock prices.

The Fear & Greed Index is constantly recalculated every time new data becomes available, and for some, it is an indispensable tool. So valuable, in fact, that in recent years, similar systems have been developed to measure fear and greed within the cryptocurrency industry. The original Fear & Greed Index is still published on the CNN Business website.

Factors that influence the Fear & Greed Index

You might be wondering how CNN Business could conceivably measure investor emotion in any meaningful way. There are actually seven different factors or indicators that are used in an effort to make it as accurate as possible. Those are:

Market momentum
Using S&P 500 data from the past 125 days of trading, it is possible to establish a rolling or moving average of market prices. When the index is above this average, it indicates positive momentum. When the index is below this average, it suggests investors are fearful.

Stock price strength
Using data from the New York Stock Exchange (NYSE), we can see how many stocks are at 52-week highs versus how many are at 52-week lows. When there are more highs than lows, it is a sign investors are bullish. When there are more lows than highs, investors are bearish.

Stock price breadth
The market is made up of thousands of stocks, each of which are bought and sold by investors every single day. Using data from the NYSE, CNN Business looks at the amount or volume of stocks that are rising compared to those that are falling. A high number indicates investor greed, while a low or negative number indicates investor fear.

Put and call options
As we detailed in our guide to investing, options are contracts that give investors the right to buy or sell stocks and other securities at a previously agreed-upon price and date. Puts are the option to sell and calls are the option to buy. When the ratio of puts to calls is rising and goes above 1, it indicates investors are becoming bearish.

Market volatility
We know stock prices fluctuate all the time, but sometimes those fluctuations are more frequent or more significant, which makes the market more volatile. CNN establishes volatility by looking at a 50-day moving average from the CBOE Volatility Index (VIX).

Safe haven demand
When investors are fearful, they tend to put more money into bonds, which are considered to be safer than stocks. Bonds then start to do better. Therefore, CNN also looks at the difference between bond and stock returns over the last 20 days of trading.

Junk bond demand
Junk bonds are riskier than other bonds, so CNN also compares the difference between yields for junk bonds and safer bonds options. A wider spread between these two suggests investors are being more cautious, while a greater demand for junk bonds indicates greed.

How the Fear & Greed Index works

Each of the above factors is given a score from 0 to 100, with 0 representing maximum fear, and 100 representing maximum greediness. CNN then takes the average of those scores to determine overall fear and greed in the market. The lower the score, the more fearful investors are perceived to be. The higher the score, the more greedy.

For instance, an average score of 0-25 indicates investors are extremely fearful, but an average score of around 50 suggests they are neutral. An average score of 75 or more suggests investors are extremely greedy. There are five Fear & Greed brackets in total, and they are:

• Extreme fear
• Fear
• Neutral
• Greed
• Extreme greed

Not only does the index show a current fear and greed rating based on the most up-to-date data, but it also offers historical ratings. You can see the average score at the previous close, as well as those from one week ago, one month ago, and one year ago. You can also view the score on a timeline to see how it has fluctuated over the past year.

What are the benefits of the Fear & Greed Index?

Many experts believe that current market prices do not accurately reflect the true value of a security because of external factors, such as market sentiment and how investors feel. That’s why fundamental analysis exists. Therefore, the biggest benefit of the Fear & Greed index is that it gives us an indication of whether investors are currently feeling fearful or greedy.

By combining the index with other analytical tools, it may be possible to determine whether stock prices are overvalued or undervalued as a result of fear and greed. It may be possible, for example, that certain stocks are actually much cheaper than they should be, simply because investors are currently fearful and aren’t willing to pay current market prices.

The Fear & Greed Index is widely considered to be a reliable tool that accurately reflects the state of the market, and it has certainly been accurate plenty of times in the past. However, it should not be the only tool investors use in their decision-making process.

What are the problems with the Fear & Greed Index?

The biggest problem with the Fear & Greed Index, according to some skeptics, is that like fear and greed themselves, it has the potential to encourage impulsive, irrational decisions. For instance, an investor may be more likely to buy simply because they see that other investors are greedy, or they may be more likely to sell when others are fearful.

This is why the Fear & Greed Index should never be the only tool used by an investor when they are trying to determine how best to act.

How can the Fear & Greed Index help crypto investors?

Although cryptocurrency is more volatile than stocks, the cryptocurrency market generally follows the stock market when it comes to activity and sentiment. When stocks are down, cryptocurrency is down. When stocks are up, cryptocurrency is up.

A big reason for this is that many of the factors that impact stock prices — such as supply, demand, economic conditions, and politics — also affect cryptocurrency prices. With that being the case, the Fear & Greed Index can also be a useful tool for cryptocurrency investors when it comes to determining market sentiment and how others feel about pricing.

In recent years, however, Fear & Greed indexes specifically designed for cryptocurrency have been developed. Alternative.me offers one of its own, and like the original index from CNN, it uses various trends, mostly based on search trends, to determine sentiment around cryptos.

References

• Fear and greed index
• Fear and greed
• Fear and greed index
• Are bitcoin price and equity markets returns correlated