The Fear and Greed Index may sound like the title to some kind of cautionary tale for investors but it’s actually a quite useful tool that can point you in the right direction for strong returns. In short, the index is a way of gauging investor sentiment that was put together by CNN Money. It is essentially based on two very simple principles:
Fear sends share prices downwards.
Greed results in over-inflated share prices.
Extreme fear lies at one end of the spectrum as the value given reaches zero, whereas anything approaching 100 represents extreme greed. The value is updated on a daily basis using the following separate indicators:
stock price strength
stock price breadth
put and call options
junk bond demand
How far these separate data points are swinging from their average value is factored into each new reading of the index.
The Crypto Fear and Greed Index
While CNN’s equities index is what investors will typically think of when they hear the words ‘fear and greed index’, it’s not the only one. For example, similar tools exist for examining the world of cryptocurrency.
These include Alternative.me’s Bitcoin Fear and Greed Index.
The logic is essentially the same, with data being used to produce a reading that lies somewhere on the spectrum between extreme fear and extreme greed. Once again, extreme fear is interpreted as pushing crypto prices downwards and extreme greed is seen as producing the opposite effect.
Data inputs used in determining the standing of the index include Bitcoin volatility, momentum and volume, and even sentiment on social media. The idea is that this can help prospective investors decide when to pounce on Bitcoin and other cryptocurrencies more generally.
Advantages of the Fear and Greed Index
Humans are emotional creatures and, though it may not always seem like it, most investors are human. When people see others enjoying great returns they want their own slice of the pie, and when they see people running for the hills they are just as liable to start packing up the car and speeding off after them.
As such, the advantages of using a tool like this are exactly what you might expect. Namely, it can help you to avoid paying through the nose for overvalued stocks and scoop equities up on the cheap when nobody else is interested in playing the game.
It’s also a pretty reliable indicator of general market health.
For example, the last time the index registered ‘extreme greed’ was in early November, just prior to the major turn in stock market fortunes we have witnessed in the last six months or so.
Since then the index has largely fluctuated between fear and extreme fear, reaching a low reading of just 7/100 on 12 May. This date is slap bang in the middle of the inflation fears that have been troubling investors for months now.
Disadvantages of the Fear and Greed Index
One thing that is very important to note if you want to use the fear and greed index to help with your investment decisions is that it’s not much of a forward-looking tool.
Let’s break that idea down a little bit.
If the index shows extreme fear, as it does at the time of writing, one might assume that it’s a fantastic time to invest as stocks are undervalued. But what if this sentiment is sustained? An investor who jumps at the first sign of fear might be jumping on board in just the first of many dips.
That’s why, particularly if you’re playing the short game, using something like the fear and greed index to advise your decisions is an extremely risky move. The index is essentially a good way of tracking broad trends in market sentiment and can help with making moves that have a longer-term outlook.
That being said, you’ll need to combine it with other methods of analysis such as fundamentals to really use the index properly.