The Fear and Greed Index
The Fear and Greed Index is a relatively new phenomenon in the world of trading. It was created by CNN Money as a way of measuring how much traders are willing to spend on stocks during times of fear or greed. The index suggests that traders are willing to spend more than what a stock is worth when greed is high and pay less than what a stock is worth when fear is the driving factor. The index has been embraced by many traders and economists, but others remain skeptical of its value.
What Is the Fear and Greed Index?
The Fear and Greed Index was created to see how emotions can affect prices on the stock market. It analyzes how much stocks are selling for compared to their intrinsic value. It is measured on a daily, weekly, monthly, and yearly basis.
Emotions can come into play when buying and selling stock. If the trader is afraid that the market is about to collapse or a company is about to go under, they may sell valuable shares for less than what they are worth. Greed can have the opposite effect. Traders may buy shares for more than what they are worth if they are feeling greedy or want to own a sizable share of the company.
Instead of analyzing how traders feel at the moment, the index looks at several factors that often correlate to market volatility.
How Is It Calculated?
The Fear and Greed Index weighs seven factors when analyzing how much buyers’ emotions may be affecting stock prices. These include:
- Stock Price Momentum, which measures the stock’s performance on the Standard & Poor’s 500 Index (S&P 500) versus its 125-day moving average (MA).
- Stock Price Strength, which measures the number of stocks hitting 52-week highs versus those hitting 52-week lows on the New York Stock Exchange (NYSE).
- Stock Price Breadth, which analyzes the trading volumes in rising stocks against declining stocks.
- Put and Call Options, which measure the extent to which put options lag behind call options, which often signifies greed. If call options lag behind put options, it indicates fear.
- Junk Bond Demand, which measures appetite for higher-risk strategies by measuring the spread between yields on investment-grade bonds and junk bonds.
- Market Volatility, which measures the Chicago Board Options Exchange Volatility Index (VIX) concentrating on a 50-day moving average.
- And Safe-Haven Demand, or the difference in returns for stocks versus Treasuries.
All factors receive a score from 0 to 100. A score of 50 is considered neutral, while anything above or below is considered out of the ordinary. The index is calculated by taking the equal-weighted average of all seven factors.
How to Use the Fear and Greed Index
Traders can use this index to get a sense of the prevailing mood in the stock market. This may be limited to a particular company or industry, but a major sell-off or buying spree could easily spill into other markets.
If the index indicates fear, it may be a sign that the market is about to take a turn for the worse, but it can also lead to buying opportunities. If the index is correct, stocks will be selling below their intrinsic value during times of fear. Buyers can use this opportunity to buy up stocks for a fraction of their normal cost. If the fear turns out to be for naught, the stock price will eventually rebound, and the buyer will make a profit.
If the index indicates greed, stocks will be trading above their intrinsic value. Many people may be trying to get in on the action, which can drive stock prices higher than usual. Traders may want to avoid buying certain stocks during this time. If they own the stock, they can sell it for more than what it would normally be worth to make a profit.
The Crypto Fear and Greed Index
The emotions can apply to crypto trading as well. The crypto market tends to be extremely volatile, and traders can use the Crypto Fear and Greed Index to see how fear and greed may be affecting prices.
The crypto index is published on the Alternative.me website. The creators believe that fear and greed can have just as big an effect on crypto prices as they do on traditional stocks. During times of greed, buyers will often flood the market looking for digital currencies, due to a fear of missing out, which drives prices higher than usual. The opposite happens when buyers are afraid that the market is about to crash. People who own crypto will begin selling it for less than what it is worth.
The Bottom Line
Fear and greed can lead some investors to make irrational decisions when buying and trading stock. Strong emotions can affect stock prices in a variety of ways, but this index is just one way of measuring the current mood of the market.