Fear & Greed Index: What It Is & How It Works
In the investment realm, fear and greed are powerful emotions that can influence investor behavior which, in turn, can impact the stock market. The Fear and Greed Index, developed by CNNMoney, is a multi-factored gauge of stock market sentiment designed to identify which of those emotions may be driving the stock market at any given time.
Fear & Greed Index Explained
Fear is what drives investors to flee the market in panic when it turns bearish, and greed is often at the root of "irrational exuberance" that can lead to stock market bubbles. When those sentiments change, from fear to greed or vice versa, it can predict a change in the stock market's direction. The premise of the Fear and Greed Index is that:
- Excessive fear can lead to stocks becoming oversold or undervalued, which is a buy indicator.
- Unrestrained greed can result in stocks becoming overbought or overvalued, which can trigger mass selling.
To this extent, CNN's Fear and Greed Index is seen as a contrarian tool, measuring the levels of fear and greed in the market so investors can buy when others are fearful or sell when everyone gets too greedy.
In theory, by understanding the current stock market sentiment, that is, which emotion may be driving the market at any given time, investors can manage their risk and make effective allocation decisions. For example:
- If the sentiment turns bearish: stocks move in a downward trend and investors might increase their allocation of cash to minimize risk.
- When sentiment turns bullish: stocks begin to recover and investors may want to increase their allocation toward equities.
However, this is not as clear as it seems as, the best buying opportunities often present themselves when prices are low and the best selling opportunities present themselves when prices are near their peak.
How The Fear and Greed Index Works
The Fear and Greed Index is a compilation of seven different indicators that measure investor behavior.
- Stock price momentum
- Stock price strength
- Stock price breadth
- Put and call options
- Junk bond demand
- Market volatility
- Safe-haven demand
The index tracks how much the individual indicators deviate from their averages compared to how much they normally diverge. The index gives each indicator equal weighting in calculating a score from 0 to 100, with 100 representing maximum greediness and 0 signaling maximum fear.
Components of the Fear & Greed Index include:
1. Stock Price Momentum
Tracks the S&P 500 versus its 125-day moving average to measure how the companies are being valued.
2. Stock Price Strength
Tracks the number of stocks hitting their 52-week highs and lows to indicate whether they're becoming overvalued or undervalued.
3. Stock Price Breadth
Tracks the volume of stock shares trading up versus those declining, which can indicate bullish or bearish sentiment.
4. Put and Call Options
Tracks the ratio of call option trades (the option to buy a stock) versus put option trades (the option to sell a stock) as a bullish or bear indicator.
5. Junk Bond Demand
Tracks the spread between the yields of investment-grade bonds and high-yield bonds as an indication of investor confidence in bonds.
6. Market Volatility
Tracks the CBOE Volatility Index (VIX) as an indication of investor expectations for volatility 30 days out. Rising expectations may indicate increasing fear.
7. Safe-Haven Demand
Tracks the difference in stock returns versus the return on Treasury bonds as an indication of investors' risk appetite.
TIP: CNN updates the Fear and Greed Index daily. It breaks down each indicator and how it is performing at the moment, with a fear-greed assessment—from Extreme Fear to Extreme Greed among investors as in the following example.
Source: CNN
It then aggregates those assessments up into a composite score as represented by the following chart.
Source: CNN
Finally, it plots the score over time from a historical perspective. You can see how the index performed at key points in the stock market's behavior.
Source: CNN
The Fear and Greed Index for Crypto
With the cryptocurrency market, Bitcoin in particular, garnering so much attention, it was only a matter of time before someone came up with a Crypto Fear and Greed Index. Displayed and updated every eight hours on the Alternative.me website, the index uses four sets of data to calculate its 0 to 100 (Extreme Fear to Extreme Greed) score.
The data include:
- Current volume: measured against historical data to indicate the current level of greediness or fearfulness in the market.
- Open interest: also compared to historical data, with high open interest indicating more greed in the market
- Social media sentiment from Reddit and Twitter: can reveal shifts in sentiment
- Search data from Google and Bing: search volume and trends for cryptocurrency terms can also indicate changing sentiment
As with the stock market, crypto market volatility is influenced by fear and greed, perhaps more so because there are no underlying fundamentals for assessing the market. All investors have to react to is market sentiment, which is primarily driven by emotions, making the Crypto Fear and Greed Index a useful tool. As the creator of the Crypto Fear and Greed Index, Alernative.me describes it:
"With our Fear and Greed Index, we try to save you from your own emotional overreactions."
Pros & Cons of the Fear and Greed Index
The Fear and Greed Index has its proponents and detractors. It's met with some skepticism by the parts of the investment community that claim it encourages market timing. Others who follow it see it as a helpful tool when combined with fundamentals and other analysis tools to assess market sentiment.
Pros
- When combined with other forms of analysis, being able to identify peak greed or fear can be useful for investors trying to pick the optimal time to enter or exit the market or a position.
- Sentiment indicators such as the Fear and Greed Index can be used to validate other fundamental or technical analyses and vice versa.
- Fear and greed sentiment indicators can alert investors to their own emotions and biases that can influence their decisions. For example, an extreme fear indication could help investors avoid herd mentality when logic says to do otherwise.
- The CNNMoney Fear and Greed Index relies on the collective, equally weighted readings of seven indicators, making it less susceptible to an overweighted influence of a single indicator.
Cons
- It's never advisable to rely solely on market sentiment. The readings from the Fear and Greed Index should only be considered within the context of other factors.
- Any signs of a significant market correction or coming bear market don't present themselves in sentiment indicators; instead, they are typically revealed through economic trends and activity.
- Market sentiment cannot predict a black swan event, such as a pandemic or terror attack or other macro-economic events that can move the markets. The only defense against such market-moving events is a properly diversified investment strategy.
Takeaway: While the Fear and Greed Index can be a useful tool, it shouldn't be used in isolation. Instead, it is most useful when used to confirm other key indicators or readings.
Bottom Line
Fear and greed are powerful emotions that can influence the direction of the stock market. The Fear and Greed Index attempts to harness those sentiments to inform investors when too much fear or greed may be driving the market, acting as a contra indicator to guide their buy and sell decisions. While the index can be a useful tool to gauge market sentiment, it should only be used in the context of a thorough analysis using technical and fundamental indicators.
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