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Unveil the mechanism behind the Fear and Greed Index, a key tool to help understand market sentiment.
The Fear and Greed Index is a stock market sentiment indicator developed by CNN Business that gauges investors’ emotional extremes to assess their inclination towards risk-taking or risk-averse behaviour. By measuring the market’s pulse through a variety of factors, such as volatility, momentum, and safe-haven demand, this index provides valuable insights into the current stock market environment.
Here we take a look at the index’s key components and explain how the Fear and Greed Index works.
The CNN Fear and Greed Index gauges investor sentiment, assessing risk-taking or risk-averse behaviours in the stock market.
Calculated using seven market indicators, it offers insights into market trends and trading psychology
The index operates on a scale of 0 (extreme fear) to 100 (extreme greed), with 50 being the neutral zone.
Factors influencing the index include stock market trends, economic indicators, global political climate, and market sentiment
Traders can use the index to help identify trends, time entry and exit points, and assess overall risk appetite in the markets.
The Fear and Greed Index was introduced by then CNN Money (now CNN Business) in 2012 to track the prevailing sentiment of the US stock market. The index analyses seven distinct market indicators and acts as a barometer in assigning a numerical value ranging from 0 to 100.
Calculating the CNN Business-developed Fear and Greed Index involves seven market indicators:
Stock price momentum: This indicator measures the S&P 500 Index’s (US500) performance relative to its 125-day moving average (MA).
Stock price strength: To work this out, the number of stocks hitting 52-week highs and lows on the New York Stock Exchange (NYSE) is compared.
Stock price breadth: This indicator involves analysis of the trading volume in advancing and declining stocks on the NYSE.
Put and call options: The put/call ratio of option contracts is calculated, comparing the trading volume of bearish put options to bullish call options.
Market volatility: The CBOE Volatility Index (VIX) is used to assess market volatility and investor anxiety.
Safe-haven demand: The performance of stocks versus bonds is evaluated, as investors typically seek bonds during the times of fear.
Junk bond demand: The spread between yields on investment-grade bonds and high-yield (junk) bonds is evaluated to access the junk-bond demand.
Each of these seven indicators is standardised and assigned a value between 0 and 100. The average of these values is then calculated to determine the overall Fear and Greed Index score.
As mentioned earlier, the index operates on a scale from 0 to 100, with 0 representing extreme fear, 50 denoting a neutral sentiment, and 100 signifying extreme greed. Typically, extreme fear indicates that investors are pessimistic and may have oversold assets. Conversely, extreme greed suggests that the market might be overbought.
Investors and traders can use the index to complement their trading strategies by incorporating market sentiment into decision-making. It’s important to note, however, that the index should not be the sole determinant for making decisions; rather, it may be used in conjunction with other technical and fundamental tools.
Meanwhile, the Fear and Greed Index historical data can provide insights into how emotional extremes have influenced the markets in the past. For example, in March 2020 the index reflected extreme levels of fear, bottoming out as low as 8, as the world faced the global pandemic.
Fear and Greed Index historical data shows extreme fear during the March 2020 pandemic-induces market crash.
In the world of cryptocurrencies, there is a separate sentiment analysis tool named the Crypto Fear and Greed Index. Introduced in 2017 by the website Alternative.me, the index aims to evaluate the prevailing sentiment in cryptocurrency markets.
Similarly to CNN Fear and Greed, the crypto index operates on a scale 0 to 100, with 0 representing extreme fear, 50 signifying neutral sentiment, and 100 indicating extreme greed. The crypto index uses various data sources, such as market volatility, dominance and momentum, social media trends and surveys to evaluate the sentiment.
Stock market trends: This is one of the key factors that influence the index, as it takes into account various aspects of the stock market, such as price momentum, market breadth and volatility. For example, during a bull market the index is likely to reflect higher levels of greed, while a bear market would tend to push the index towards fear.
Economic indicators: Data points such as gross domestic products (GDP) growth, employment rates, inflation, and consumer confidence help determine the overall health of the economy. Hence, positive readings would generally contribute to an optimistic market sentiment, driving the index towards greed. On the other hand, negative readings may lead to pessimism, promoting fear in the markets.
Global political climate: Events such as elections, trade wars, and geopolitical tensions can bring uncertainty into the markets, affecting investor sentiment. During periods of stability, the index is more likely to reflect greed, while uncertainty can cause excessive fear.
Market sentiment: Positive news and strong financial reports tend to boost market sentiment and push the index towards greed, while negative news or disappointing results may cause fear among investors.
Other factors: Some of the other factors that may influence the Fear and Greed Index include investor psychology, herd mentality and historical market patterns such as boom and bust cycles and seasonality.
Fear and greed is considered a contrarian indicator.This means that it creates signals that suggest that the current market trend may be on the verge of reversing. Although the way traders use the index would depend on their strategy and overall approach, here are some of the popular methods.
Trend followers can use the index to help in spotting the prevailing market trends. Some of the ways in which they can do it include (but are not limited to):
Combine with moving averages: One way to identify trends using the index is by comparing it with moving averages. A rising moving average indicates a potential shift towards greed, while a falling one signals a potential move to fear. By comparing the two indicators, traders can potentially confirm or disprove their assumptions about the prevailing market trend.
Spotting sentiment shifts: Watching out for abrupt changes in the index can help in identifying a shift in market sentiment. For example, a sudden spike in the index from extreme fear to extreme greed may indicate a market reversal, while a decline from greed to fear could signal a potential downturn or correction.
Analysing divergence: Traders can compare the Fear and Greed Index with stock market indices, such as S&P 500 or Nasdaq Composite to reveal divergences. For instance, if the market is reaching new highs while the index is falling towards fear, it may suggest a lack of conviction in the rally and an impending reversal.
When the index shows extreme fear, it can signal that stock prices may be undervalued and oversold as investors sell off their holdings in panic, indicating that a potential reversal from bear to bull market is likely. On the contrary, when the index shows extreme greed, it may mean that the market is overbought and a trend reversal from bull to bear market may occur in the near future.
Traders can use this information to determine their entry and exit points of opening and closing positions. It’s important to note, however, that the index shouldn’t be used on its own as it can create false signals. Traders may want to use other indicators to help them potentially confirm or disprove market signals.
Traders can use the index to evaluate the overall market risk. For example, when it indicates high levels of fear, it suggests that market participants are risk-averse and pessimistic about the future, hence the sentiment is risk-off. In such scenarios, traders may consider a more conservative approach, focusing on risk management, and seeking out safe-haven assets or defensive sectors.
On the other hand, high levels of greed may indicate a risk-on sentiment, it may signal that market players are overly optimistic and may be overlooking potential risks. In this situation, traders may want to consider caution and prepare for potential corrections or reversals.
The Fear and Greed Index is a sentiment barometer for investors and traders seeking to understand the emotional undercurrents driving the stock market.
Through its seven market indicators, the index provides a comprehensive view of investor sentiment, helping traders to make more informed decisions, identify trends and evaluate risk appetite. However, it’s essential to remember that the index may not be used in isolation. Instead, it should complement other technical and fundamental tools to reinforce the decision making.
As the market continues to evolve and change, having a finger on the pulse of investor sentiment can prove invaluable. By staying attuned to the ebb and flow of fear and greed, traders may be able to better navigate the complexities of the financial markets. So, stay curious, and don’t underestimate the power of emotions in the world of finance.
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