What Is Stock Market ‘Fear and Greed Index’ And How It Works?

Equities can be analyzed from different perspectives, including investors’ sentiment – whether investors are bullish or bearish on them. The Fear and Greed index is one of the important tools that help to measure investors’ fear and greedy sentiments on a daily, monthly or annual basis. When used correctly, the tool can be very helpful in making prudent stock investing decisions. However, it cannot be seen as the sole factor in making investment decisions. Excessive greed can increase stock prices as individuals keep buying and bidding up prices.

Let us understand the fear and greed index and how you can use it to make the most of your investments. As an investor, the first step is to understand demat account meaning and then go to complex terms of the stock market.

What is the Fear and Greed Index? 

Greed and fear are the two powerful emotions that drive stock markets. The Greed and Fear Index, developed by CNNMoney, determines these two critical emotions that decide if the investors are ready to spend on specific stocks. This index is based on the idea that excessive fear will decline share prices, and greed will bring opposite effect because the investors are emotional. Investors act reactionary instead of having self-control during testing times. 

• It helps to know whether investors are bearish or bullish on the stock market. 
• It measures stock market movements based on these two emotions daily, weekly, monthly, and yearly. 
• It also helps to know if the stocks are fairly priced by looking at investors’ emotions. 

Fear makes investors sell stocks in a panic, which results in declining stock prices that may go below their intrinsic value and turn bearish. The result will be the opposite when investors are greedy, and it can lead to stock market bubbles. 

How The Fear and Greed Index Works

CNN’s Index is based on seven indicators. Each factor is measured on a scale of 0 – 100 and equally weighted to generate the index value. The index value helps marketers and investors make sound investing decisions in the stocks. 

• 0 to 49 means fear
• 50 denotes neutral
• 51 to 100 shows greed

The Fear and Greed Index helps to understand the current market sentiment, and investors can manage risk with effective decisions. Investors use the Index as a guide for stock selections in delivery and intraday trading. The Fear and Greed Index is valued roughly once every trading day. Using the Index, they can buy the stock when others are fearful and good companies are undervalued.

A change in sentiments, from greed to fear or vice versa, can identify the change in the market trend. 

• Excessive fear can lead to oversold or undervalued stocks, triggering buys.
• Extreme greed can result in overbought or overvalued stocks, triggering mass selling.

Factors To Measure Investor Sentiment 

The following seven factors generate the Fear and Greed Index Value to measure investor sentiment:

1. Stock Price Strength: It tracks the number of stocks hitting 52-week highs compared to those at 52-week lows. A lower number of stocks touching 52-week highs than 52-week lows points to fear.
2. Stock Price Breadth: It tracks the trading volumes of rising stocks relative to those declining. Lower trading volumes in rising stocks than in declining stocks mean fear. 
3. Market Momentum: It tracks the performance of the Standard & Poor’s 500 Index (S&P 500) relative to its 125-day average. A lower relative performance means fear.
4. Junk Bond Demand: It confines the investors’ appetite to adopt higher-risk strategies by tracking the spread between investment-grade and junk bonds’ yields. A greater yield spread shows fear with lower junk bond demand. 
5. Safe Haven Demand: It determines the stock and Treasury bond returns. The lower relative performance reveals fear.
6. Market Volatility: CNN employs Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX), to know investors’ expectations for volatility. Lower expectations show declining fear. 
7. Put and Call Options: It tracks the ratio of call vs. put option trades. A lower put/call ratio indicates greed.

Based on each factor, it aggregates assessments based on the Index rating that ranges between 0 (extreme fear) and 100 (excessive greed) and provides a composite score.

Using the Fear and Greed Index

The Index is considered less of a research tool and more of a market-timing tool. The tool is generally used to know the entry point into the market. Suppose the Index value is 90 (extreme greed). It indicates that the stocks are overvalued. Investors following the Index may be prompted to sell their stock holdings.

Consideration 

What investors need to consider is that they cannot wholly rely on investor sentiment measures, like the Fear and Greed Index, to make

investment decisions. They need to research fundamentals also, like economic growth, companies’ revenue and earnings, etc. 

Thus, when used correctly, the fear and greed index can guide investors to make smart investments. 

Investments in the securities market are subject to market risk, read all the related documents carefully before investing.