Fear and Greed Index
The fear and greed index describes the “mood” of the market or stock traders. It makes it easier for market participants to analyze market data, such as the trend of stocks and behavioral patterns of other investors. Low values of the index indicate that investors are not ready to get involved in risky projects. High levels often indicate that the market is overvalued and investors are getting more careless.
Fear and Greed Index explained
Fear and greed are strong emotions that often influence the behavior of investors, especially in the cryptocurrency market. The fear and greed index is an indicator that shows which of these emotions prevails in the market.
The developers of the fear and greed index are sure that understanding the general mood of investors helps to predict movements in the stock market. When fear is the dominant sentiment, there is a decline in the stock value and they trade below their intrinsic value. If greed dominates among investors, then shares are actively bought and traded for much more than their true value.
Some experts remain increasingly skeptical about the use of the index as an investment tool as it is based on the theory of choosing a good time to make buying or selling decisions.
The fear and greed index ranges from 0 (extreme fear) to 100 (extreme greed) and is calculated with seven indicators:
- Market Momentum. It is a technical indicator, the purpose of which is to measure the amount of change in the price of a financial instrument over a certain period of time. It compares the current level of the S&P 500 to its average value over the past 125 days. If it exceeds the 125-day indicator, fear dominates the market.
- Stock Price Strength. It shows the number of stocks touching new 52-week highs against stocks that have set 52-week lows on NYSE within the last 52 weeks.
- Stock Price Breadth. It indicates how many stocks are advancing and declining.
- Put and Call Options. Here, the put/call options volume is measured. If there are more put options, then fear prevails in the market, if there are more call options, then greed is the dominant sentiment.
- Junk Bond Demand. Junk bonds are bonds with a high yield but a low credit rating, which means a high level of risk. If the demand for such assets increases, then the greed of investors can be seen in the market. Conversely, if the demand for the securities decreases, then investors panic and will soon begin to sell risky assets.
- Market Volatility. The volatility indicator — VIX, or the so-called "Fear Index", is calculated here. It indicates traders' expectations for the volatility of the S&P 500 broad market index for the next 30 days. The indicator is calculated with the quotations of supply and demand for option contracts.
- Safe Haven Demand. When fear becomes the predominant emotion, investors tend to sell risky securities and boost demand for safe-haven assets, such as gold or U.S. Treasury bonds.
The movement patterns of the crypto market, whether bullish or bearish, is not only influenced by the strength of supply and demand, but is also determined by a crypto fear and greed index. The crypto fear and greed index similarly measures crowd psychology in the cryptocurrency market.
Advantages of applying Fear and Greed Index
Psychologists have come to the conclusion that greed has a great impact on people and makes us act irrationally, meaning incongruent with logic. Most investors, who rely on emotions when making financial decisions, lose money in the stock market. Most economists advocate relying on the fear and greed index while making investment decisions and taking on risk.
The fear and greed index is considered to be a good analytical indicator that enables investors to better understand the movements of the stock market. Аfter the largest bankruptcy of the U.S. investment bank Lehman Brothers, the S&P 500 was at its lowest close in nearly 3 years and the index indicated “extreme fear” in the market.