Understand how the Fear and Greed Index works. Learn how to monitor market development & interpret stock prices with this index.
What is the Fear and Greed Index
The Fear and Greed Index is an index developed by CNN Business to measure investor sentiment. It shows how emotions affect how investors pay for stocks. The index provides insight into whether a stock is reasonably priced at a certain point in time.
The Fear and Greed Index is calculated daily, weekly, monthly and annually and is based on the logic that excessive fear lowers stock prices and excessive greed raises prices. How the Fear and Greed Index works Investing is often emotional and reactive. Indicators of fear and greed can influence the investor and the decision to buy or sell stocks.
Fear and Greed Index Use
The purpose of the Fear and Greed Index is to help measure market sentiment along with analytical tools. The Fear and Greed Index can measure market development. Based on the premise that fear causes stocks to trade below their true value and greed drives uptrends, the index is considered either a legitimate investment research tool or a barometer of market timing.
It was a reliable indicator of stock markets. The index fell to a low of 12 in September 2008, when the S&P 500 hit a three-year low after the bankruptcy of Lehman Brothers and the near death of insurance giant AIG. By contrast, it was above 90 in September 2012 when global stocks rose after the Federal Reserve and the third round of quantitative easing.
On March 12, 2020, at the height of the pandemic, the index fell to a two-year high as stocks fell 10% and entered a bear market after President Donald Trump announced a travel ban to the United States amid the growing coronavirus fears. In November 2020, the index recorded more than 75 extreme austerity categories in the region as optimism about a coronavirus vaccine grew.
Indicators of Fear and Greed
The index measures seven indicators on a scale of 0-100. The index is calculated as an equally weighted average of both. A reading of 50 is considered neutral, and higher numbers indicate greed. Smaller numbers hover in the fear categories. The seven indicators of fear and greed are:
Price Momentum: A measure of the SPX 500 relative to its 125-day moving average (MA).
Stock Price Strength: The number of stocks that hit a 52-week high versus a 52-week low on the New York Stock Exchange (NYSE).
Stock Value Breadth: Analyze the trading volumes of rising stocks versus declining stocks.
Put and Call Options: The rate at which put options are lagging, indicating greed, or being outnumbered, indicating fear.
Junk Bond Demand: Measures the difference between investment grade bond yields and junk bond yields.
Market Volatility: CNN measures the Cboeand#039 Volatility Index (VIX) based on the 50-day MA.
Safe haven demand: The difference between equity and treasury yields.
Interpreting the Fear and Greed Index
As noted, a lower Fear and Greed Index value implies a fearful investing climate, and a higher number can indicate investor optimism. Labels are applied to index ranges, so you can easily interpret the prevailing sentiment:
Fear & Greed Sentiments By Index Scores
- 0-24: represents extreme fear
- 25-44: shows a more modest level of fear
- 45-55: expresses a neutral market
- 56-75: means investors are feeling greedy
- 76-100: shows extreme greed among investors
If you agree with the logic that investor sentiment pushes stock prices up or down, you can use the Fear and Greed Index as a general valuation indicator. An index value below 45, in the fearful range, could mean investors are generally underpricing stocks. When the index ticks above 55, “greedy” or optimistic investors may be pushing prices too high. The more extreme the index value, the more extreme the effect.
Pros And Cons Of Using The Fear And Greed Index
One advantage is that it provides a consistent measure of investor sentiment, which can complement fundamental analysis for value investors and contrarians. Additionally, it can be applied to various trading strategies, including value, momentum, contrarian, and swing trading.
However, there are limitations to consider. The index is not predictive, as its data is historical, and sentiment in the market can change rapidly. Any shifts will only be reflected in the index after the fact. Furthermore, there’s a risk of over-reliance on the Fear and Greed Index. It’s best used in conjunction with other research and analysis, as a low index value doesn’t automatically indicate a favorable time for value investors to buy.
In conclusion, understanding the Fear and Greed Index is crucial for investors seeking insights into market sentiment. While it provides valuable data, it’s important to recognize its limitations and use it in conjunction with other analyses.
For a more comprehensive understanding of mastering emotions in trading and making optimal investment decisions, we highly recommend reading our article, “Forex and Crypto Trading Psychology: Mastering Emotions for Optimal Investment Decisions.” . Delving into the intricate world of trading psychology, this article offers advanced knowledge, equipping readers with the emotional intelligence necessary to navigate the complex terrain of financial markets successfully.
