Decoding the Fear and Greed Index: What Does It Say?
Decoding the Fear and Greed Index: What Does It Say?
Emotion is at the root of action, which inspired CNNMoney (now CNN Business) to create a new metric that gauges the day-to-day emotions of stock traders. Known as the Fear and Greed Index, the scale analyzes seven metrics to determine the average stock investor's sentiment. The crypto community also created its own Fear and Greed Index that monitors digital asset prices.
While the Fear and Greed Index isn't perfect, it has become a widely discussed barometer of trading activity. Find out how this index might help you analyze trends in the stock and crypto markets.
CNNMoney introduced the original Fear and Greed Index in 2012. Using seven data points from the United States stock market, CNN analysts assign a score between zero and 100 each day to calculate how investors feel. The closer this score trends toward zero, the more fear there is in the market. In contrast, a score of 100 indicates a strong appetite for risky equities.
The idea behind the Fear and Greed Index is that fear and greed are the primary motivators for stock price movements. The more fearful traders are, the more likely stocks will fall into a bear market. Conversely, the more greed there is in a market, the greater the chance stocks are in an unsustainable bubble.
Components of the Fear and Greed Index in the stock market
Remember, CNNMoney tracks seven stock market metrics to arrive at its daily fear versus greed score. According to the company, it calculates each of the following traits with equal weight:
Overall stock market momentum: To determine where today's stock market stands versus historical trends, CNNMoney analyzes the gap between the Standard & Poor's 500 (S&P 500) and the 125-day moving average. When the S&P 500 is above this trendline, it signals a bull market. Conversely, if the S&P 500 slips below the 125 moving average (MA), it could highlight a bear trend.
Strength or weakness in stock prices: Next, CNNMoney calculates the number of companies on the New York Stock Exchange (NYSE) trading at their 52-week highs and 52-week lows. The more stocks are at their lows, the more fear generates in the market.
Breadth in stock trading volumes: This third metric looks at whether there's a greater volume of stocks with increasing or decreasing prices. Volume measures how many total shares exchanged hands in a given trading session.
Options activity: Options are contracts that track the prices of assets like stocks and ETFs (exchange-traded funds). "Call options" are bullish, while "put options" are bearish. When there's more demand for put options, it suggests there's more fear in the market and vice versa.
Junk bond demand: Junk bonds are debt issued by institutions or companies with low creditworthy scores. Since there's a greater chance that the debt issuer won't pay their loans, these bonds are considered a high-risk investment. Generally, investors will only flock to junk bonds when there's excessive greed in the market.
VIX Score: Created by the Cboe Options Exchange, the VIX is a widely followed chart that tracks the volatility in the S&P 500. CNNMoney analyzes the 50-day score of the VIX when calculating the Fear and Greed Index.
Demand for safe-haven assets: Lastly, CNNMoney looks at the money inflows into the stock market versus treasuries. Since treasuries are considered safe-haven assets, most investors turn to them during times of uncertainty.
Does the Fear and Greed Index work for Bitcoin?
As Bitcoin gained more mainstream attention during the 2017 bull run, the website Alternative.me decided to create a "Crypto Fear and Greed Index," modeled on CNNMoney's index. Launched in February 2018, Alternative.me's Fear and Greed Index has the same 0-100 scale, and it updates once per day. Instead of tracking stock prices, Alternative.me solely focuses on data related to cryptocurrencies.
Unlike CNNMoney's chart, the Crypto Fear and Greed Index monitors six features. Also, Alternative.me doesn't weigh each data point equally. Here are the core components of the Crypto Fear and Greed Index, according to the company’s website, along with a pie chart:
(Alternative.me’s Fear and Greed Index)
Crypto price volatility: At 25% of the total score, price volatility is a significant factor driving Alternative.me's ranking. Every day, analysts monitor the price of large-cap cryptocurrencies relative to their 30- and 90-day averages.
Crypto market volume: Like crypto volatility, daily trading volume accounts for 25% of the Crypto Fear and Greed Index's score. More buying volume increases the greed score, while higher selling pressure decreases the score.
Social media sentiment: Alternative.me monitors the average responses for crypto-related keywords on sites like Twitter and Reddit. The positive or negative response rate influences the index by 15%.
Survey results: In addition to social media, Alternative.me reviews crypto surveys on StrawPoll. These results could account for 15% of the crypto fear and greed index.
Bitcoin dominance: Traditionally, when crypto investors are fearful, they flock to large-cap projects like Bitcoin (BTC). BTC dominance measures how much of the global crypto market cap is in Bitcoin. A higher BTC dominance score may signal greater fear in the market. This metric accounts for 10% of the Fear and Greed Index.
Crypto search trends: Alternative.me also looks into how many people are searching for crypto keywords using data from Google Trends. Like BTC dominance, this score accounts for 10% of the index's ranking.
Is the Fear and Greed Index accurate?
Generally, the index correlates with many bull and bear runs. For instance, Alternative.me's index averaged scores in the 90s range in February 2021. Bitcoin rose to more than $60,000 in the following months. The Crypto Fear and Greed Index also started falling in May 2021, when BTC dipped to around $30,000 before rebounding in September and November to more than $60,000.
While these indexes often reflect trading activity in the stock and crypto markets, they aren't the most scientific pricing tools. A fair amount of the data in Alternative.me's score is subjective (e.g., survey results and social media responses). There are also questions about the reliability of using data points like BTC dominance. As more altcoins (especially stablecoins) enter the cryptocurrency market, some analysts believe BTC dominance will become increasingly irrelevant.
While these indexes seem to correlate with real-time price data, they’re not the only metric to use when making trading decisions. The Fear and Greed Index provides a general read on market sentiment, but nothing can predict the future.
Using the Fear and Greed Index
Some people rely on the Fear and Greed Index for an overview of how investors feel about stocks and crypto. This data may help inform one’s opinion on where asset prices are headed and whether you should enter or exit the market.
Some investors use the Fear and Greed Index as a "contrarian" indicator, which means they may view times of “extreme fear” as the best buying opportunity for their favorite assets. Conversely, when there's too much greed in the market, investors may want to consider selling assets or protecting their long-term portfolio with hedging techniques.
For example, assume you hold a significant position in Apple’s stock (AAPL) when the Fear and Greed Index is in extreme greed. During this time, you could purchase put options as a hedge against your long position. Put options bet that the price of an underlying asset will decline by a set date. Should AAPL’s price fall, you’ll lose less money while retaining your shares.
Remember that the Fear and Greed Index isn't a robust scientific metric. Also, since anyone can access both Alternative.me and CNNMoney's indexes, they are public knowledge. Nobody who reads these reports has an insider advantage. While reading the Fear and Greed Index is fine, it shouldn't be the cornerstone of a market’s analysis. It's best to consult the index as one aspect of crypto or stock research.
The Fear and Greed Index is a widely referenced source in the stock and crypto markets. While you can glean some insights from these indexes, they can never tell you everything about market dynamics. Other factors like the relative strength index (RSI), sector-specific news, and macroeconomic trends can give you greater insights into why asset prices are moving up or down. While referring to the Fear and Greed Index can be helpful, it's best to compare these results with further research before making any decisions.
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