Investor sentiments play a significant role in driving the market prices, direction, volatility, and volume. Hence, tracking these sentiments and emotions of investors becomes essential. Developed by CNN Money, the Fear & Greed Index measures two main emotions that influence how much investors are inclined to pay for stocks.
The fear & greed index is measured on the basis of seven different factors. Each factor is equally weighted and gauged from 0 to 100 and to generate the index value. Thus, in theory, the Index can gauge whether the stock market is reasonably priced.
Understanding the Index
Excessive fear tends to drive down share prices, and too much greed tends to have the opposite effect is the underlying logic behind the Index.
People tend to get FOMO (Fear of missing out) which makes them greedy when the market is rising. Quite often, it is also seen that people sell their holdings in the irrational reaction to seeing red numbers. With the help of the Fear & Greed Index, you can be saved from your own emotional overreactions. There are two simple things assumed:
- Extreme fear can signal that investors are too worried, which could be a buying opportunity.
- When Investors are too greedy, that means the market is due for a correction.
Calculation of the Index
As described earlier, the fear & greed index is calculated based on seven different factors – each factor is gauged from 0 to 100 and equally weighted to generate the index value.
- Stock Price Strength
This factor is a ratio of the number of stocks on the New York Stock Exchange (NYSE) reaching 52-week highs relative to reaching hitting 52-week lows. A greater number of 52-week lows indicates versus 52-week highs indicates fear and vice versa.
- Stock Price Breadth
Stock Price Breadth is based on the trading volumes of rising stocks relative to declining stocks on the NYSE. A greater volume of rising stocks versus declining stocks indicate greed and vice versa.
- Market Momentum
Momentum is the speed of price changes in stock. The performance of the S&P 500 relative to its 125-day average measures the market momentum. A higher performance relatively indicates greed and vice versa.
- Put and Call Options
The extent to which call options lag behind put options, signifying fear, or surpass them, indicating greed.
- Safe Haven Demand
Bonds are usually considered safer compared to stocks. Better performance of bonds relative to the performance of stocks indicates fear and vice versa.
- Junk Bond Demand
The greater yield spread between investment-grade bonds and junk bonds indicates fear and vice versa.
- Market Volatility
A higher value of the Chicago Board Options Exchange Volatility Index (VIX) concentrating on a 50-day Moving Average indicates fear and vice versa.
The Bottom Line
Historically, the fear & greed index has been a reliable indicator of a significant change in equity markets. It can be a great tool to time entry and exit in the market. As stated by Warren Buffett, “Be fearful when others are greedy, and greedy when others are fearful.” The fear & greed index can help investors understand the general sentiment and act accordingly on their trades.
Most experts agree on a buy-and-hold strategy to be the best way of seeing returns in a portfolio over the long term. Arguably, tools such as the fear & greed index encourage investors to frequently trade in and out of stocks and generate less favorable returns.
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