What’s the Fear and Greed Index?
The Fear and Greed Index is a set of indicators that measure investors' behavior towards the market. The idea is widespread fear may lead to a stock price drop, while reckless optimism (a.k.a. greed) increases demand.
As humans, we tend to act on our primal emotions. For example, fear and greed are the primal emotions that overcome us when investing. On a scale of 0 to 100, 0 is the most fearful, and 100 is the most greedy.
When we’re at or near 0, this state of extreme fear can cause intense feelings of selling. But, on the contrary, excessive greed might encourage more “fear of missing out” or FOMO-like buying sprees.
How are Fear and Greed Calculated?
Typically, the Fear and Greed Index is a mixture of objective signals (such as stock price or safe heaven demand) and others more related to general investor sentiment (thus more difficult to measure):
- Market volatility. This is probably one of the most well-known ways to measure market sentiment. It’s based on a volatility index that showcases whether investors are buying or selling more than usual.
- Stock price strength. It’s important to note that some bonds can skew how the market looks. For instance, many tech stocks such as Amazon, Google, and Facebook created a lot of volatility in the market, especially during COVID times. Keep in mind to look at which stocks are performing well compared to others that aren’t.
- Stock price breadth. Investors are actively buying and selling thousands of stocks every day. When there’s a low or negative number, this signals the potential for a Bear Market. Generally, it indicates whether or not investors are actively buying or selling certain stocks.
- Put and call options. Options are contracts allowing investors to buy or sell stocks or other financial securities based on a set price and date. Puts are the options to sell, and calls are the option to buy. So when you see more puts to calls, this is a sign of extreme fear or more potential for a Bear Market.
- Safe haven demand. Stocks carry more risk than bonds. However, the long-term reward for investing in stocks is greater. Still, bonds tend to perform well for short-term investments and returns, so a Safe Haven Demand shows the difference between stocks and bond demand.
- Junk bond demand. These are high-yield, high-risk security and are usually issued when a company wants to raise capital quickly. Because they carry more risk, they tend to pay greater interest, and their issuers are more likely to default. Still, the opportunity to benefit from a high yield is why an investor would consider buying a junk bond.
- Market momentum. The financial market works with patterns, so it’s ideal to look at stock market levels and compare them to months prior. A general rule of thumb is to look at the 125 trading days average to see if investors are feeling positive or skittish.
Fear and Greed Index for Crypto
Even more so than the stock market, the crypto environment is influenced by emotion, as many traders are non-professionals.
These are other signs that a Fear and Greed Index related to the crypto world could or should consider:
- Dominance. The too-preponderant dominance of Bitcoin can be seen as an equivalent to using safe havens. Altcoins are more speculative assets, and their massive purchase may indicate a tilting of the scales toward Greed.
- Social Media and Trends. Many of the most considered crypto market indexes (such as CoinGecko) report an analysis of social media-related metrics and sentiment.
As mentioned earlier, cryptocurrencies were created to facilitate the transmission of value between two individuals without the intermediation of institutions (such as banks).
This, coupled with the still-present skepticism of many institutional investors, means that many crypto traders are non-professionals and thus susceptible to general sentiment.
How to Use the Fear and Greed Index?
Consider the Fear and Greed Index as a temperature check. Knowing the overall market sentiment can help you better plan your move as an investor. It can also help you avoid herd mentality or acting too irrationally with your emotions.
Generally, it’s a great way to see when to enter the market. Just don’t use it as the sole factor in making financial decisions.
However, when many people start selling or buying, it could be a great strategic move for you to do the opposite before a major crash one way or the other happens.
Still, don’t use this as the sole indicator, and the longer you start looking at the market and patterns and try out investing, the better you’ll become at figuring out your next move.
Is the Fear and Greed Index a Good Indicator?
The financial market is highly volatile, adding cryptocurrency adds another layer of turbulence. The Fear and Greed Index helps understand the crypto market's direction. However, as mentioned before, it can’t be used as the only way to make a safe investment decision.
In general, do comprehensive research from various sources: you can start with a fundamental analysis, then a technical one, and then mix it up with a sentiment-related one, such as the Fear and Greed Index.
Emotions are powerful motivators to have us behave irrationally. And often, investment can have us act emotionally and reactionary since it comes to our money, the basic need to survive, and safety. Still, history has shown us that the Fear and Greed Index has been a reliable indicator to know the equity of markets.
For instance, the aftermath of the Lehman Brothers bankruptcy in September 2008 was one of the all-time lowest periods for the index.
Drawbacks and Criticisms
The drawback is that the index relies heavily on human emotion and behavior, which can often be irrational. It also can increase our chances of following the herd mentality. This is where people tend to conform to a group they belong to, especially in the investment community. But you can also consider when everyone ran out to stock up on toilet paper when COVID lockdowns first started.
Most people would agree that the buy-and-hold strategy is the best for investing. This means buying some stocks and holding out for the long term to get the most out of your investment.
Is Fear More Powerful than Greed?
At the basic level, our primary goal is to survive. This is why we’re hardwired to view the world negatively and to be more motivated to avoid pain than seek pleasure.
Let’s imagine a squirrel. If a squirrel eats a few nuts and then spends the rest of its time in bliss, it’ll die come winter because it didn’t have this fear about not finding any nuts for the winter. So rather than collecting and hiding nuts to survive the winter, it remained complacent in its happiness with this short-term reward.
Thus, fear is much more powerful and a more significant motivator than greed. It’s what helps us survive.
It’s also a tactic often used in marketing. Consider how many times you received emails that this is your last chance to buy something or that there’s only one room left in this hotel room, so you have to book now or forever lose out. It’s also why Machiavelli chose to rule with fear rather than love.
How Do You Overcome the Fear or Greed Sentiment?
These two emotions play vital roles in the psychology of trading. Fear is the fight-or-flight instinct that we all have. So you might have a fear of losing money or of an underperforming market. This is normal. Greed is when we lust for something or feel more intense about what we have. This can manifest as greed to keep your current money or make more money. It’s our instinct to want to do better and achieve great things.
Define a plan (and stick to it).
Still, just like any emotion, you can overcome the fear or greed sentiment or at least keep it in check. Start by having a definite plan. When you set goals and know what you’re willing to lose, you can stop overthinking and regretting when you lose money. You also have to forget any get-rich-quick mentality. Many people think investing can make you millions overnight, but it’s not true. It’s a game of patience and waiting out for the long term.
Keep a trading journal.
You can also consider keeping a trading journal that’ll keep you accountable. You’ll be able to assess if your investments are aligned with your goals and better learn the market batters. It can also allow you to rebalance your portfolio if needed.
Don’t give up learning.
You should always aim to learn and improve your knowledge about the market. This includes market fundamentals, market functions, and technical aspects. This will help you make better and more informed decisions in the future.
Include an AI-driven trading engine to avoid emotional decisions.
The ability to involve our emotions in decision-making has been a driving force behind many of the most crucial choices in human history.
Even now, without our dreams and ambitions, we wouldn't be able to fuel the engine that drives us toward progress and excellence.
However, relying too much on emotions can be a problem on certain occasions.
Emotional investment (the rationale behind the Fear and Greed Index itself) can fuel upward or downward price movements, even though objective factors only partially justify this.
Peccala can support investors at any level by analyzing the likelihood that a movement in market charts may or may not constitute a trend.
Probabilistic analysis can be a valuable ally, especially in a world ruled by volatility (see crypto).
Join our waitlist and see Peccala for yourself!