The fear and greed index is a popular tool developed by CNN Money to help investors measure the sentiment of the market. The index uses seven important gauges in the market to see whether investors are getting fearful or greedy.

The idea behind the index is that fear and greed are the two foundations of the financial market. Greed happens when there is a fear of missing out (FOMO). That means that when an asset is doing well, many investors tend to buy so as not to miss out in the rally. Similarly, when an asset’s price is dropping, these investors want to short and make money as it drops.

Fear happens when the opposite of greed happens. In forex, investors can sell-off a currency because of negative economic data like manufacturing PMI and employment data. In stocks, investors can sell a company’s shares when it releases weak financial results or when it is going through fundamental issues.

The fear and greed index studies seven key aspects of the market and comes up with a dashboard of where things are. The index ranges between 0 and 100, with zero being a sign of extreme fear and 100 signalling extreme greed in the market. It is updated every day. For example, during the height of the coronavirus pandemic, the index dropped to below 10 as most investors sold their holdings. In the rally that followed, the index rose to below 90.

How the fear and greed index is calculated

Fear & Greed index displays financial sentiment, looking at seven key metrics in the market. These are:

Stock price strength

The strength of stock prices looks at the performance of stocks in the market. Ideally, when more stocks are trading above their 52-week highs, it means that investors are getting greedy. Similarly, when many stocks are trading below their 52-week lows, it sends a picture that there is extreme fear about earnings in the market. When the number of stocks hitting their 52-week lows and 52-week highs is almost equal, the stock price strength is neutral.

Junk bond demand

Junk bonds refer to corporate and sovereign bonds that have a lower credit rating. A good example of junk bonds are the highly-indebted oil and gas companies or retailers that have limited chances of surviving for years. For example, before their bankruptcies, companies like Chesapeake Energy and Sears Holdings were junk companies. As such, this sub-index of the fear and greed index looks at the spread between yields of junk companies and high-grade firms.

Market volatility

Market volatility is an important index used in calculating the fear and greed index. While there are many measures of market volatility, analysts at CNN Money use the CBOE volatility index, also known as VIX. This index is calculated by looking at the activities in the options market in the S&P 500. Generally, the VIX rises when there is more volatility in the market and falls when there is limited volatility. As shown below, the VIX rose to multi-year highs at the height of the coronavirus pandemic.

The VIX rose at the height of the pandemic

The VIX rose at the height of the pandemic

Safe-haven demand

CNN Money looks closely at the demand for safe havens when calculating the fear and greed index. Ideally, in periods of extreme fear, investors tend to rush to safe-haven assets. These include safe government bonds and high-grade corporate bonds. They specifically look at the performance of stocks versus these safe-haven assets in a 20-day period.

Stock price breadth

The stock price breadth measures the volume of stocks that are climbing versus the volume of falling companies. To do this, they use the McClellan Summation Index. The idea behind this is that a strong rally should be justified with higher volume and vice versa.

Put and Сall ratio

This sub-index of the fear and greed index looks at the number of put and call options in the market. For starters, a put option gives you the right (but not the obligation) to sell a stock at a future date. A call, on the other hand, gives you the right to buy an asset at a future date. As you can see below, the put and call ratio rose to a high of 1.28 at the height of the pandemic.

Put and call ratio chart

Put and call ratio chart

Market momentum

Finally, the fear and greed index looks at the momentum of the S&P 500 index, which is the most popular indices in the United States. In this, they look at where the index is trading in comparison to the 125-day moving averages. Ideally, the higher the index is above this moving average, the higher the momentum. This can be a sign of more greed in the market.

S&P 500 and the 125-day moving average

S&P 500 and the 125-day moving average

How to use the fear and greed index when trading

The fear and greed index is a useful tool that tells you where the stock, CFD, and the forex market is. However, it is not necessarily an indicator of where a certain currency pair will go.

When there is extreme fear in the market, many investors tend to rush to the so-called safe-haven currencies. Examples of the most common safe-haven currencies are the US dollar, Japanese yen, and Swiss franc. The dollar is a haven because of its role as the world’s reserve currency. As such, when there is a lot of fear, investors tend to rush to it. The Japanese yen is viewed as a haven because of the foreign holdings Japan has while the Swiss franc is a haven because of the neutrality of the Swiss government.

At the same time, when the fear and greed index is showing extreme greed, investors tend to move away from these safe-haven currencies. The chart below shows that the US dollar index reached a multi-year high when the fear and greed index reached a multi-year low.

US dollar index and the fear index

US dollar index and the fear index

Final thoughts

The fear and greed index is an important tool that measures sentiment in the market. The index looks at seven important benchmarks and plots whether investors are greedy or fearful. While it is not a usual indicator, you can use it to explore the state of the market and know the best assets to buy or short.