What Is the Fear and Greed Index?
The fear and greed index was developed by CNNMoney to measure two of the primary emotions that influence how much investors are willing to pay for stocks. The fear and greed index is measured on a daily, weekly, monthly, and yearly basis. In theory, the index can be used to gauge whether the stock market is fairly priced. This is based on the logic that excessive fear tends to drive down share prices, and too much greed tends to have the opposite effect.
- The fear and greed index was developed by CNNMoney to measure two of the primary emotions that influence investors.
- It is based on the premise that excessive fear can result in stocks trading well below their intrinsic values.
- The index also suggests that greed can cause stock values to rise far above what they should be worth.
- CNN examines seven different factors of fear and greed and scores investor sentiment on a scale from 0 to 100.
- The website Alternative.me offers a crypto fear and greed index for cryptocurrency markets.
How the Fear and Greed Index Works
The fear and greed index is a tool used by some investors to gauge the market. It is based on the premise that excessive fear can result in stocks trading well below their intrinsic values while, at the same time, unbridled greed can result in stocks being bid up far above what they should be worth. Some skeptics dismiss the index as a sound investment tool as it encourages a market timing strategy rather than a buy-and-hold strategy.
The CNN fear and greed index examines seven different factors to establish how much fear and greed there is in the market. They are:
- Stock Price Momentum - A measure of the Standard & Poor's 500 Index (S&P 500) versus its 125-day moving average (MA).
- Stock Price Strength - The number of stocks hitting 52-week highs versus those hitting 52-week lows on the New York Stock Exchange (NYSE).
- Stock Price Breadth - Analyzing the trading volumes in rising stocks against declining stocks.
- Put and Call Options - The extent to which put options lag behind call options, signifying greed, or surpass them, indicating fear.
- Junk Bond Demand - Gauging appetite for higher risk strategies by measuring the spread between yields on investment-grade bonds and junk bonds.
- Market Volatility - CNN measures the Chicago Board Options Exchange Volatility Index (VIX) concentrating on a 50-day MA.
- Safe Haven Demand - The difference in returns for stocks versus treasuries.
Each of these seven indicators is measured on a scale from 0 to 100. The index is computed by taking an equal-weighted average of each of the indicators. A reading of 50 is deemed neutral, while anything higher signals more greed than usual.
There is also a crypto fear and greed index that is published by the website Alternative.me. According to the website, crypto market behavior is just as emotional as traditional markets. When the market is bullish, people can experience fear of missing out. Also, people often sell their coins as part of an irrational reaction to seeing red numbers. Similar to the CNN index, if the index shows "extreme fear," it can be a sign that investors are too worried, but this could be a buying opportunity. If the index shows that investors are getting "too greedy," that means the market is due for a correction.
Benefits of Using the Fear and Greed Index
According to some academics, greed can affect our brains in a way that coerces us to set aside common sense and self-control and provoke change. While there is no generally accepted research on the biochemistry of greed, when it comes to humans and money, fear and greed can be powerful motivators.
The fear and greed index has historically been a reliable indicator of a significant change in equity markets.
Many investors are emotional and reactionary. Behavioral economists show decades of evidence of the effect of fear and greed on investor decisions and present a strong case for monitoring CNN’s index.
History shows that the fear and greed index has often been a reliable indicator of a turn in equity markets. According to Attic Capital, the index sank to a low of 12 on Sept. 17, 2008, when the S&P 500 fell to a three-year low in the aftermath of the Lehman Brothers bankruptcy and the near-demise of insurance giant AIG. By contrast, it traded over 90 in September 2012 as global equities rallied following the Federal Reserve's third round of quantitative easing.
Plenty of pundits agree that the fear and greed index is a useful indicator provided that it is not the only tool used to make investment decisions. Investors are advised to keep tabs on fear so that they can leverage buying opportunities when stocks dip and view periods of greed as a potential indicator that stocks might be overvalued.
Criticisms of the Fear and Greed Index
Skeptics downplay the fear and greed index as a legitimate investment research tool and see it more as a barometer for market timing. The skeptics argue that a buy-and-hold strategy is the best way to invest in equities and worry that tools such as the fear and greed index encourage investors to frequently trade in and out of stocks. History, they add, shows that such an approach generates less favorable returns.
Despite proponents of the fear and greed index, most experts agree that a buy-and-hold strategy is the best way to see returns in a portfolio over the long term.
Fear and Greed Index FAQs
What Is the Fear and Greed Index?
The fear and greed index is a way to gauge stock market movements and whether stocks are fairly priced. The theory is based on the logic that excessive fear tends to drive down share prices, and too much greed tends to have the opposite effect.
What Is the CNN Fear and Greed Index?
CNNMoney developed a fear and greed index; however, there is also a crypto fear and greed index that was developed by the website Alternative.me.
How Is Fear and Greed Calculated?
For the CNN fear and greed index, seven different factors are graded to establish how much fear and greed there is in the market. The seven factors are the following: stock price momentum; stock price strength; stock price breadth; put and call options; junk bond demand; market volatility; and safe-haven demand.
How Do Fear and Greed Affect the Decisions of Investors?
Many investors are emotional and reactionary, and fear and greed are the two predominant emotions affecting investors. According to some researchers, greed and fear can cause us to set aside common sense and self-control and provoke change. When it comes to humans and money, fear and greed can be powerful motivators.
How Do You Overcome Fear and Greed in Trading?
The best way to overcome fear and greed in trading is to develop a trading plan and then stick with it. A trading plan can prevent acting on impulses. Actions that might deviate from a plan include overleveraging, removing stops on losing positions, or doubling down on losing positions. Another way to decrease any emotional effect of trades is to lower the trade size. Another way to reduce fear and greed is to keep a trade journal. These actions help to hold an investor accountable for their trades.