Did you know that fear and greed are the two factors that drive financial markets?
Yes, the two feed each other and form a constant cycle. You can see it in politics, in sports, and of course in everything related to money.
Somehow the technical indicators and fundamental factors are helpful to predict the price of an asset. Still, none of them are equal to the Fear & Greed index.
If you are thinking about investing for the medium or long term, you probably have doubts about how and when to do it. For that reason, we will talk about this indicator created by a group from the Economics section of the CNN channel.
Taking advantage of this indicator can be complicated; therefore, this article will describe how it is composed and how to use it to plan your investments or trading in the markets.
What is the Fear and Greed Index?
If you are looking for an indicator that considers both data and human emotions, this will be your favorite. It is composed of a scale that goes from 0 to 100, as you will see in the picture below.
The parameters are the following:
0 to 24 – Extreme Fear
25 to 49 – Fear
50 to 74 – Greed
75 to 100 – Extreme Greed
Seven indicators are taken into account to calculate these values and represent them in the index, which are:
Stock price momentum: it considers the S&P 500 price versus its 125-period Moving Average. If the price is above the Moving Average, and it is also reaching new highs, it will be Greed only for this indicator.
Junk bond demand: this is the spread between junk bonds and investment-grade bonds. The higher the demand for junk bonds, the more optimistic and confident investors are.
Market volatility: is measured based on the VIX (CBOE volatility index), which is used to determine the volatility of the S&P 500.
Usually, it stays close to a 50-period Moving Average in calm periods. But when periods of uncertainty arrive, volatility increases and moves away from it, indicating extreme fear.
Safe-haven demand is calculated by the spread between the yield of stocks versus US Treasury Bonds. If there is fear in the market and volatility starts to increase, investors will begin to move their money from stocks to these bonds to protect their money.
Put and call options: This is the ratio between the trading volume of Put (sell) and Call (buy) orders in the stock options market.
If the indicator is very high, it means that there are more Put orders. In contrast, when it is low, Call orders predominate.
Stock price strength: The stocks’ strength is calculated by measuring how many stocks have reached all-time highs or lows in the last 52 weeks on the New York Stock Exchange.
Stock price breadth: The breadth is composed of the trading volume between bullish and bearish stocks based on the McClellan Volume Summation Index.
When the breadth grows, more stocks participate in the move of the stock indices. Conversely, when the breadth declines, fewer stocks join the indices’ price action.
What makes the Fear and Greed Index helpful to investors?
Determining how hot or cold the market is based on fear or greed can help us assess our investment strategies.
Trying to use this indicator and succeed is not an easy task. Still, it can give you that general perspective that is so important for decision-making. Let’s look at an example with the stock market crash in 2008-2009.
A financial crash like the one in 2008 does not happen overnight. However, since the early 2000s, US banks were making a series of risky investments, such as granting loans to customers who had insufficient income to repay them.
Clients of these banks were running out of money to pay. Then, in September 2008, one of the most important banks in the United States called Lehman Brothers Holdings declared bankruptcy.
As you can imagine, the years before this fall, there was a lot of optimism due to the banks’ confidence. As a result, people were taking loans to buy high-value properties that they could not afford with their salaries.
When the crash occurred, people quickly went from optimism to extreme fear. At that point, no one thought about investing anymore, but surprisingly, the S&P 500 began a bullish cycle that would last for years and reach new price highs.
Something similar happened again in 2020 with the beginning of the pandemic.
Countries began to close borders and decree quarantines, causing large investors to withdraw their money and sell shares. As a result, the S&P 500 index fell more than 30% in less than two months.
After all the fear generated by the fall, the markets once again began a significant recovery. Technology stocks and cryptocurrencies were some of the assets that reached record highs.
When we analyze this indicator’s history, we see a relationship between fear and the subsequent economic growth of the markets and greed with the following fall of the stock market.
Suppose you want to take advantage of downturns in markets to invest. In that case, you should apply one of Warren Buffet’s principles which says: “Be fearful when others are greedy and greedy when others are fearful.”
We must not get carried away by emotions. Instead, we should take advantage of the fact that everyone is selling. In crises, you get the best discounts on multiple stocks in which you can invest for the long term.
Finding the best time to invest or trade with this indicator is possible as long as we analyze the overall market sentiment and data.
We should not invest only considering this indicator because several additional factors can affect the market. Still, it is undoubtedly advantageous to incorporate it into our repertoire.