Investing in market trends and decision-making processes is often driven by emotions. We like to think the stock market will always look like it is based on rational logic, but humans play a massive role in stock price action. The market is pushed by greed and fear, two of the most powerful emotions, in unpredictable ways. Learning how to navigate the market well and understand these emotional shifts is crucial. The Fear & Greed Index is one of the most valuable tools for gauging these emotional swings.
What Is the Fear & Greed Index?
The Sentiment analysis tool Fear & Greed Index measures the mood of the stock market, an indicator of how investors feel. This index, created by CNN Business, gives investors a view on whether the market is driven by greed or fear, which can drive stock prices up or down than their actual estimated value.
In theory, the Fear & Greed Index can tell us whether the market is overpriced or underpriced, depending on the level of optimism or pessimism in the market. The logic behind an index is that when there is too much greed, stock prices rise as people become overoptimistic. On the other hand, if fear overwhelms the market, prices tend to drop as people become too scared.
While the Fear & Greed Index is useful, keep in mind that the market sentiment doesn’t always coincide with the real value of stocks. Fundamentals often deviate from sentiment and thus can give rise to overvalued or undervalued markets.
How Does the Fear & Greed Index Work?
The Fear & Greed Index works on a scale from 0 (extreme fear) to 100 (extreme greed). When the index goes up, the market becomes more driven by greed; when it goes down, it becomes dominated by fear. The index is calculated by averaging seven different market indicators, each denoting a different aspect of investors’ sentiment. These are leading indicators that give a global picture of the market and help an investor know if the market is in a fear—or greed-driven cycle.
The Seven Key Indicators of the Fear & Greed Index
Market Momentum
Market momentum is tracked by comparing the S&P 500 with its 125-day rolling average. When the S&P 500 is above this average, it signals positive momentum, indicating the market is fueled by greed. This upward shift often suggests that investor optimism is pushing prices higher than their estimated value. On the other hand, a decline below the 125-day average signals negative momentum and a fearful market.
Stock Price Strength
This component takes into account the ratio of the number of stocks listed on the NYSE that are trading at 52-week highs versus the number of stocks trading at 52-week lows. If many stocks are trading at highs rather than lows, it indicates that investors are excited about the overall market, and the adage greed comes in marching in applies. Conversely, more stocks at their 52-week lows mean fear and bearish market sentiment.
Stock Price Breadth
The McClellan Volume Summation Index is a stock price breadth indicator that measures the ratio of advancing stocks versus declining stocks. Rising trading volume often signals a market driven by greed, where investors actively buy in anticipation of higher prices. In contrast, declining volume reflects a more fearful sentiment, as market participants pull back, unsure of the direction ahead.
Put and Call Options
Another way the Fear & Greed Index is calculated is by the ratio of put options to call options. Put options allow investors to sell stocks, betting on price declines, while call options give them the right to buy, reflecting optimism and expectations of higher prices. The put-to-call ratio is higher when they anticipate a market decline (fear), while a lower ratio indicates they are optimistic and greedy.
Market Volatility
The 50-day moving average of the CBOE Volatility Index (VIX) serves as a key indicator of market volatility. Known as the “fear gauge,” the VIX tracks fluctuations in the S&P 500, offering a real-time view of market sentiment. High volatility means that there is a tendency to fear, and low volatility means investors are greedy.
Safe Haven Demand
This indicator tracks the performance of stocks compared to Treasury bonds over the last 20 days. Investors tend to run for safe assets when bonds outperform stocks, which generally points to fear. When stocks outperform bonds, this means greed because investors are more ready to take risks.
Junk Bond Demand
Other indicators in the index include the demand for junk bonds (calculated by comparing yield spreads between junk bonds and investment-grade bonds). A smaller yield spread implies less risk, which implies greed, while a wider spread implies greater risk, which implies fear.
Interpreting the Fear & Greed Index
The Fear & Greed Index is a quick snapshot of market sentiment. It gives values for the seven indicators, finds the mean, and arrives at the final score from 0 to 100. The final value tells you where the market stands emotionally, with the following ranges representing different levels of investor sentiment:
- 0-24: Extreme Fear
- 25-44: Fear
- 45-55: Neutral
- 56-75: Greed
- 76-100: Extreme Greed
These ranges can help you learn about the current state of the market and make sense of where to invest. For example, the number in the extreme fear range (0-24) could have an index value, which shows an underpriced (and potential buying opportunity) for the contrarian investors. On the other hand, a high greed value (96-100) may indicate that the stocks are too expensive and due for a correction.
Using the Fear & Greed Index to Inform Your Investment Strategy
Identifying Buying Opportunities
Contrarian investors and value investors looking to buy stocks when the market is overly fearful and prices are depressed will often use the Fear & Greed Index. If the index is low (less than 25), stocks are underpriced, making this a good potential buying opportunity. These kinds of investors believe that the market blows itself out of proportion into fear, and once the sentiment becomes more positive, prices will correct upward.
However, when the index shifts into the higher ranges (i.e., above 55), it may indicate that the market has become too greedy (investors tend to bid up stock prices), and the future of the stocks could be inflated. This could signal value investors to become wary or even avert buying or selling their stocks if they believe stocks are overvalued.
Timing the Market
Short-term traders and momentum investors could also use the Fear & Greed Index to time the market. For instance, short-term traders may be looking for price rebounds in the market after it has corrected itself, as the index reveals signs of extreme fear. Conversely, when seeing the index at extreme greed, traders may predict a pullback and adjust their strategy accordingly.
Emotional Self-Check
Perhaps the most useful tool for self-reflection was the Fear & Greed Index. The index can be a stopper when you begin to feel too emotional about your investments—feeling too much of either fear in the downturn or greed in a market rally. You know where the market is in terms of sentiment and are able to make better decisions that align with your investment goals, in contrast to being influenced by the mood of the general market.
The Crypto Fear & Greed Index
The Crypto Fear & Greed Index, developed by Alternative.me, operates in much the same way as the traditional Fear & Greed Index, specifically for the cryptocurrency market. Given cryptocurrencies’ inherent volatility, sentiment plays an even more significant role in price fluctuations. Just like the Fear & Greed Index for stocks, the crypto version measures market sentiment on a scale from 0 to 100.
Besides, the Crypto Fear & Greed Index uses similar factors to those in the stock market version, such as market volatility, momentum, and social media trends. It also considers the dominance of Bitcoin and other cryptocurrencies in the market, helping investors gauge how much fear or greed affects crypto prices.
Pros and Cons of Using the Fear & Greed Index
Pros:
- Complement to Other Analysis: The Fear & Greed Index complements other forms of analysis (fundamental and technical) well. It may prove useful in determining whether investors’ views remain in line with a stock’s or a market’s fundamentals.
- Timing Market Cycles: Understanding market sentiment gives investors an edge in timing market cycles, making sense of when to enter and exit. Low sentiment can mean the asset is undervalued, while high sentiment can mean an overheated market.
- Emotional Check: The index can help investors recognize when their emotions might cloud their judgment, especially during extreme market conditions.
Cons:
- Not a Predictive Tool: The Fear & Greed Index is not based on predicting future market behaviour but past behaviour. Sentiment turns fast, and so the index becomes a lagging indicator.
- Dangerous Over-Reliance: Understanding trading decisions based only on the Fear & Greed Index is dangerous. Investment decisions need to be based on other indicators and research. The index must be employed in a more balanced manner, not singled out as a stand-alone solution.
- Subjectivity: The index is based on market sentiment, which could be subjective. Sentiment is significantly influenced by external factors such as geopolitical events or regulatory news, so it can be challenging to predict with complete accuracy.
Conclusion
The Fear & Greed Index is a useful gauge of investor sentiment, revealing when investor emotions—be it greed or fear—have a bearing on price. By tracking this index, investors will have a more straightforward path ahead to determine whether they should buy markets in a fearful state or take profit in a greedy state. But like any tool, it should not be used in isolation. The Fear and Greed Index can assist you in understanding the market a little better when combined with other analysis techniques, to help keep your investing decisions as emotionless as possible.
