Initially developed by CNNMoney, the Fear & Greed Index has grown to become one of the most popular gauges of investor sentiment across the stock market.
Put simply, the fear & greed index is based upon the understanding that excess fear in the market can result in a stock trading below its intrinsic value and vice versa; excess greed can cause a stock value to rise above what it should be worth.
How is the Fear & Greed Index calculated?
The Fear & Greed Index is calculated using seven key indicators. These are:
- Stock Price Momentum
The S&P 500 (Standard and Poor’s 500) is compared against its 125-day moving average (MA). The S&P 500 is an index that tracks the performance of 500 of the largest companies listed on the US stock exchange and is one of the most commonly followed equity indices for traders.
- Stock Price Strength
Calculated as the number of New York Stock Exchange stocks hitting their 52-week high or low.
- Stock Price Breadth
The volume of rising shares versus those where the price is declining.
- Put and Call Options
The put/call ratio compares the trading volume of bearish put options against the volume of bullish call options.
- Junk Bond Demand
Calculated as the spread between yields on investment grade bonds and junk bonds. Junk bonds are rated BB or lower by S&P, or Ba or lower by Moody’s. Junk bonds pay a higher yield to investors as a result of the higher risk associated.
- Market Volatility
Volatility in the market is calculated using the VIX, a real-time market index that details the market’s expectations for volatility for the upcoming 30 days. If a VIX reading is under 20, this indicates that investors have fewer fears, whereas a measure of over 30 implies investors are generally fearful.
- Safe Haven Demand
Treasuries represent safe havens for investors, their performance and returns are compared to that of stocks.
All seven indicators are equally weighted in the calculation of the final index. The indicators are measured against their average peaks and troughs. The Fear and Greed Index is ranked on a scale from 0 to 100. A rating of 50 is deemed as neutral, anything below is deemed as more fear than usual, whereas above 50 signals more greed than would be expected typical.
At time of writing in December 2021, the current index ranks at 25, Extreme Fear. This has suffered an extreme swing from the November 2021 ranking of 69, greed, with the market swing strongly influenced by the rapid rise of the Omnicron variant of COVID-19.
At the height of the financial crisis on September 17, 2008, the Fear and Greed Index sank to a record low of 12. This was driven by the S&P 500 plummeting to a three-year low in the aftermath of the bankruptcy of Lehman Brothers and the near collapse of insurance giant AIG. This highlights a SP500 fear and greed index correlation.
How to use the Fear & Greed Index for trading
The fear & greed index is often used as a contrarian tool. That is to say, when the fear and greed index indicates one way, typically the trader will buck against the market trend and act in the opposite direction.
An extreme fear rating is often a sign that investors are too worried, presenting buying opportunities for undervalued stocks. Conversely, the market is expected to be due for a correction when investors are calculated as being too greedy.
A common example cited of market greed is the Dot-com bubble of the late 1990s. The speculative investment bubble centred around new startup companies that were internet focused. Investors’ greed spurred on further greed, leading to heavily overpriced securities and stocks, eventually leading to the burst bubble.
Why is the Fear & Greed Index a useful tool for traders?
Many traders are driven by emotional and reactionary factors. Historically, the fear & greed index has been a reliable market sentiment indicator of upcoming corrections or turns in equity markets. Many behavioural economists point to years of quantitative data showing the effect of fear and greed on investor decision making.
The well known trader Warren Buffet was quoted as saying that wise traders should be “fearful when others are greedy and greedy when others are fearful”, a sentiment supported by the Keynesian’ Animal Spirits’ theory of irrationality in the market.
Criticisms of the Fear & Greed Index
Despite the popularity of the fear &greed index, sceptics downplay the strengths of using the index, arguing that it encourages overactive trading. Instead, many experts support long term buy-and-hold strategies as the best way to see portfolio returns. However, this is a classic example of the divide between day traders seeking short term opportunities, and long term investors seeking predictable outcomes.
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