The Fear and Greed Index: Definition & How it Works
What is the Fear and Greed Index?
The fear and greed index is a measure of market sentiment designed by CNN Money. The index measures levels of fear and greed seen by investors in the stock market.
It’s calculated by taking into account a variety of factors, including stock price movements, trading volume and market trends.
A high level of fear on the index may indicate that investors are concerned about the stability of the market and are more likely to sell their stocks. In contrast, a high level of greed may indicate that investors are confident in the market and are more likely to buy stocks.
It is based on the idea that extreme fear can push share prices far below their intrinsic values, whereas extreme greed could push stock prices far above their value.
The Crypto Fear and Greed Index
The crypto fear and greed index is a tool for the crypto market, similar to CNN’s index, and is published by the website Alternative.me.
According to the website, the cryptocurrency market is a highly emotional market driven by the fear of missing out (FOMO) when the market is bullish.
Alternative.me uses the following 6 measures to calculate crypto investor sentiment.
- Price volatility over the past 30 and 90 days (25% of the index)
- Market momentum and trading volume (25% of the index)
- Social media mentions on Twitter and Reddit (15% of the index)
- Surveys of the crypto market investors (15% of the index)
- Bitcoin market cap dominance (10% of the index)
- Google trends data (10% of the index).
How Does the Fear and Greed Index Work?
The fear & greed index is calculated using seven different factors to assess levels of market sentiment.
Each sentiment indicator is measured on a scale from 0 to 100, then the equal-weighted average of each indicator is taken. An index reading of 50 is considered neutral, while anything higher signals more greed and anything lower signals more fear.
- Stock Price Momentum: This measures the extent to which stock prices are rising or falling based on the S&P 500 vs its 125-day moving average.
- Stock Price Strength: This tracks the number of stocks reaching 52-week highs compared to those reaching 52-week lows on the New York Stock Exchange (NYSE).
- Stock Price Breadth: This measure looks at the trading volumes of appreciating stocks compared to depreciating ones.
- Put Options and Call Options: Options are financial contracts that allow investors to purchase or sell stocks, indexes, or other securities at a predetermined price and date. When the put-to-call ratio increases, it generally indicates that investors are becoming more anxious.
- Junk Bond Demand: This measures investor demand for higher-risk investments by comparing the spread between yields on investment-grade bonds and high-yield bonds (or junk bonds).
- Market Volatility: CNN uses the 50-day moving average of Cboe’s Volatility Index (VIX) to look at market volatility.
- Safe Haven Demand: The index uses the difference between stock returns and treasury yields to gauge investor sentiment and preference for safe-haven assets.
- Read More: Is Contemporary Art a Safe Haven Asset?
By taking these sentiment indicators into account, the fear and greed index is able to provide a snapshot of the emotional state of the stock market at any given time.
Then it’s up to investors and financial professionals to interpret this information and use it to inform their investment decisions.
What Can the Fear and Greed Index Tell You?
The fear and greed index can provide insight into the emotional state of the market, specifically, the level of fear and level of greed present among investors.
Many investors are driven by their own emotions and biases which can impact investment decisions. Using the fear and greed index can help to assess market sentiment. When paired with other market fundamentals, this can help investors make informed investment decisions.
When the index shows extreme fear — defined as an index value of 0 — this can indicate that investors are very worried about the future of the market. If fundamentals don’t match the sentiment, this could potentially be a buying opportunity for investors.
Investors can utilize the CNN index to manage portfolio risk by increasing cash allocation during market drawdowns and increasing their equity allocation when markets are bullish.
Limitations of the Fear and Greed Index
Here are a few limitations to the fear and greed index that investors and financial professionals should be aware of:
- It’s based on subjective data: The index is based on a variety of subjective factors which can be influenced by many different variables. This means that the index may not always accurately reflect the true sentiment of the market.
- It can be affected by external events: The fear and greed index can be influenced by external events, such as political or economic news, which can have a significant impact on market sentiment. This means that the index may not always be a reliable indicator of long-term market trends.
- It’s a lagging indicator: The fear and greed index is a reactive measure of market sentiment, which means that it tends to reflect changes in the market after they occur. This can make it difficult to use the index to predict future market movements.
Overall, while this index can be a useful tool for understanding the emotional state of the market, it is important to use it in conjunction with other analysis and to consider its limitations when making investment decisions.
The Bottom Line
Personal finances are an extremely personal and emotional part of many individuals’ lives, meaning that emotional responses to investment returns are useful to track and understand.
The CNN Money fear and greed index attempts to quantify investor sentiment on a scale of 0 (extreme fear) to 100 (extreme greed).
Some contrarian investors utilize this index to determine buying opportunities, while others may simply find it helpful as a check to see how investors are feeling about the future of the market.
The information in this article is for educational purposes only. It is not to be construed as investment advice or used to form the basis of an investment decision.