The Fear and Greed Index was first introduced in 2012 by CNNMoney, now known as CNN Business, to the stock and trading markets as a quantitative index to measure the sentiment of investors and traders. The Fear and Greed Index uses seven different components in the market to indicate whether the market is in a state of fear or greed.
This index is now considered a key indicator for predicting the trends of financial markets and investments, and as a trader, you should be familiar with the concept of the Fear and Greed Index and the factors affecting it. Having a proper understanding of investor sentiment will enable you to use this index effectively to determine buy or sell points in your trades.
The Meaning of Sentiment in the Market
Investor sentiment or market sentiment is one of the most important determining factors in price trends. Sentiment in the market can be both collective and emotional, or it can arise through financial crises, influencing the flow of buying and selling in the market. Sentiment in financial markets or Forex is divided into two categories: fear and greed.
Fear
Fear in the market means a strong worry or anxiety about a price decline or uncertainty about the future of the market. When fear dominates the market, investors tend to sell their assets and exit the market to avoid further losses. During this time, the market usually experiences reduced trading volume and falling prices.
Greed
Greed can be considered the opposite of fear in financial markets and Forex. When greed dominates the market, the hope for rising prices naturally increases. In such conditions, investors are more inclined to take on risks beyond the usual and may even show interest in purchasing assets with low fundamental value, hoping for quick profits.
Fear and Greed: How They Led Global Markets to Collapse?
In the 2008 financial crisis, greed and fear clearly impacted financial markets. In the early 2000s, greed led banks to issue high risk mortgage loans to low income individuals, and financial institutions pressured the housing market by purchasing these loans. This trend led to unrealistically high prices as investors believed that the housing market would always continue to grow. Their greed caused them to overlook the existing risks and enter higher risk markets.
However, in 2008, when housing prices started to decline, fear entered the market. With the rise in default rates and the bankruptcy of banks, investors panic sold their assets to avoid further losses. This fear caused people to distance themselves even from safe assets like government bonds, leading to a reduction in trading volume. As a result, markets experienced a severe downturn, and prices reached their lowest levels. Fear quickly led the market into a recession, while greed, as the driving factor, had created the price bubble.
Seven Influential Components of the Fear and Greed Index
Market Volatility
One of the factors indicating instability and fear in the market is volatility. When prices change unpredictably, investors tend to sell their assets to prevent further losses. This component leads to an increase in the fear index.
Momentum
If the market is experiencing a strong uptrend, it generally indicates optimism and increased greed among investors. Conversely, if a strong downtrend is forming, It leads to increased fear among investors and heightened panic selling.
Put/Call Ratio
This ratio reflects the demand for put options. If more investors purchase put options, it indicates a high level of fear in the market, which in turn increases the fear index.
Fund Flow
If investors move their money from riskier markets to safe assets like bonds, it signals fear in the market and increases the fear index.
Safe Haven Assets
An increase in the prices of safe haven assets such as gold and the Japanese yen usually signifies rising fear in the market. These assets become popular during times of crisis, leading to an increase in the fear index.
Market Breadth
If most stocks are in a downtrend and only a few are rising, it signals fear in the market, which reduces the greed index and increases the fear index.
Google Trends and Media Sentiment
An increase in searches related to crises or negative news reflects fear in the market. For example, during the onset of the COVID 19 pandemic, searches related to “market crash” and “economic crisis” surged, signaling public concern and heightened fear in the market, which resulted in a rise in the fear index.
Scoring in the Fear and Greed Index
To use the Fear and Greed Index, it is necessary to establish a specific scale. For this purpose, each of the seven components mentioned above is independently scored from 0 to 100, and then the average of these data points is converted into a final score. After averaging the data, the scores are divided into five different categories ranging from 0 to 100 to determine the index status, which are as follows:
0 to 24: Extreme Fear
25 to 49: Fear
50: Neutral
51 to 74: Greed
75 to 100: Extreme Greed
This scoring method allows traders and investors to accurately understand the prevailing market sentiment on a daily basis and make decisions based on it. The Fear and Greed Index, due to the use of average scores and the lack of greater influence from any specific component, is recognized as a reliable and balanced tool for identifying market sentiment.
How Professionals Use the Fear and Greed Index
To use the Fear and Greed Index professionally, it should be considered as part of your trading strategy and combined with other analytical tools. This index helps you identify market sentiment and make better trading decisions based on it. When the fear index is low, the market may be undervalued, creating an opportunity to buy. On the other hand, when the greed index is high, the market may be in a price bubble, and more caution may be needed.
This index alone is not enough and should be combined with technical and fundamental analysis. For example, when the fear index is low and technical analysis shows an uptrend, it may be a good time to enter the market. Likewise, if the greed index is high and technical analysis signals reversals, caution is advised, and it may be time to exit the market.
For risk management, using the Fear and Greed Index is important. The extreme volatility of market sentiment can lead to rapid price changes. Professional traders use this index to set stop loss and take profit levels to prevent severe fluctuations and reduce risk.
Finally, attention to long term trends is essential. The Fear and Greed Index can signal short term trends, but for long term decisions, you should consider long term changes in market sentiment and adjust your strategies accordingly.
Best Strategies for Using the Fear and Greed Index
Suitable strategies for using the fear and greed index:
Buy Strategy during Extreme Fear
When the fear index reaches a low level (0 24), the market is usually under selling pressure, and prices decline. In such conditions, the best strategy is to buy at lower prices. Traders can take advantage of these opportunities to buy valuable assets, as extreme fear often leads to an irrational decrease in prices, which can provide an opportunity to enter the market.
Sell Strategy during Extreme Greed
When the greed index reaches a high level (75 100), the market is likely in a price bubble phase. In such conditions, the best strategy is to sell or reduce risk. Traders should look for opportunities to exit the market or sell assets, as excessive greed can lead to corrections or price crashes.
Combination with Technical Analysis
The Fear and Greed Index can serve as a confirmation signal for technical analysis. For example, when the fear index is low and technical analysis also indicates an uptrend, this can be a strong buy signal. Conversely, if the greed index is high and technical analysis shows breakdowns or bearish signals, it may be time to exit the market.