Financial markets are not perfect. A major source of that imperfection is human emotion, which aggregates into prevailing investor sentiment. Broad sentiment trends can untether prices from value, pushing stocks higher or lower than they should be.
The role sentiment plays in stock market cycles is most obvious in hindsight. Today, we can look back on the dotcom bubble, for example, and see what happened. Too many investors greedily snapped up tech stocks with dangerously little regard for business fundamentals. But in the throes of tech enthusiasm that sentiment effect was much harder to discern.
Fortunately, there is a metric that can indicate how investor sentiment is influencing stock prices right now. That metric is the Fear and Greed Index , developed by CNN Business. Read on to learn what the Fear and Greed Index is, how it works and how you can use it to inform your investing process.
What Is The Fear And Greed Index?
The Fear and Greed Index attempts to measure investor sentiment. That measurement is important if you accept the logic that excessive investor fear pushes stocks lower, while investor greed pushes stocks higher. In that context, the Fear and Greed Index can signal whether stocks are underpriced, fairly priced or overpriced.
How Does The Fear And Greed Index Work?
The Fear and Greed Index is a 100-point scale. A lower number implies a more fearful bear market, while a higher number indicates a greedier, bull market climate.
The index value is an equal-weighted average of seven stock market indicators. These are explained below.
1. Market Momentum
The index measures market momentum by comparing the S&P 500 to its rolling average over the past 125 days. Positive momentum—when the current value of the index is higher than the 125-day average—skews the index towards greed. When the index is lower than the prior average, momentum is negative—a signal of investor fear.
2. Stock Price Strength
The stock price strength element of the index compares the number of NYSE stocks trading at their 52-week highs vs. those trading at 52-week lows. More highs than lows indicates a higher level of investor greed, while more lows shows a more pessimistic climate.
3. Stock Price Breadth
Trading volume can also reflect how investors are feeling. The Fear and Greed Index incorporates the McClellan Volume Summation Index, which looks at trading volume trends on strong days and weak days. Rising trading volume indicates investor greed, while declining volume signals fear.
4. Put And Call Options
A put gives you the option to sell a security at a future date, and a call allows you to buy a security later. The ratio of put options to call options can show whether investors largely expect to be selling or buying going forward.
This element of the Fear and Greed Index measures the trend in the five-day average put/call ratio. A value of 1 is neutral. Higher than 1 can indicate fear and lower than 1 implies greed.
5. Market Volatility
The index uses the 50-day moving average of the CBOE Volatility Index (VIX) to measure market volatility. VIX tracks short-term S&P 500 options activity. A rising average shows a more fearful environment, while a declining average can reflect investor optimism.
VIX is supposed to be a leading indicator of market sentiment changes, though its predictive record isn’t perfect.
6. Safe Haven Demand
When investors get nervous, they often seek safety by increasing bond exposures and reducing stock exposures. The safe haven demand element of the Fear and Greed Index measures this phenomenon by comparing the prior 20-day returns of Treasury bonds vs. stocks. When the demand for stocks is higher, investors are feeling greedier. If bonds are outperforming stocks, investors are more cautious.
7. Junk Bond Demand
The index measures junk bond demand via the yield spread between junk bonds and investment-grade bonds. When the difference in yield is smaller, investors are open to more risk or are greedier. A larger yield spread shows a more cautious or fearful investing climate.
Interpreting the Fear and Greed Index
As noted, a lower Fear and Greed Index value implies a fearful investing climate, and a higher number can indicate investor optimism. Labels are applied to index ranges, so you can easily interpret the prevailing sentiment:
Fear & Greed Sentiments By Index Scores
- 0-24: represents extreme fear
- 25-44: shows a more modest level of fear
- 45-55: expresses a neutral market
- 56-75: means investors are feeling greedy
- 76-100: shows extreme greed among investors
If you agree with the logic that investor sentiment pushes stock prices up or down, you can use the Fear and Greed Index as a general valuation indicator. An index value below 45, in the fearful range, could mean investors are generally underpricing stocks. When the index ticks above 55, “greedy” or optimistic investors may be pushing prices too high. The more extreme the index value, the more extreme the effect.
When the sentiment is neutral, stock prices are more likely to be priced appropriately.
Using The Fear And Greed Index To Inform Your Investments
Generally, you can use the Fear and Greed Index, along with other cues, in two ways. First, the index may help you understand how emotions are influencing your investing decisions. Secondly, the index can help you recognize good buying opportunities.
Identifying Your Own Emotions
Say you’re compelled to sell everything at a time when the Fear and Greed Index is lingering below 25. The low index level should be a cue to think more deeply about where your motivation lies. Have your holdings permanently deteriorated, such that they need to be sold right now? Or, are you getting lured into panic by a predominantly fearful climate?
The opposite situation can be instructive also. If you’re aggressively buying up shares at a time when the index value is very high, that’s a signal to pause. Think about your core investing approach and evaluate whether you’re still following it with discipline.
You want to avoid loosening your investing parameters just because the market is hot. That approach can backfire later, creating more volatility when the market turns.
Recognizing Buying Opportunities
Your investing style will dictate how you use the index to identify buying opportunities. Value investors and contrarian investors will see buying opportunities when the index value is low, in the fearful range.
Short-term traders may see the opposite. Quick gains are easier to come by when investors are feeling confident and stock prices are on the rise. The short-term trader may prefer buying in those greedier climates, as long as they’re protected from quick reversals with stop-loss or stop-limit orders.
Pros And Cons Of Using The Fear And Greed Index
As with any investing resource, there are pros and cons to using the Fear and Greed Index to inform your investing. Here are the main advantages and disadvantages to know.
Pro: A consistent measure of investor sentiment can complement fundamental analysis. Particularly for value investors and contrarians, the Fear and Greed Index can validate buying opportunities uncovered through other analyses.
Pro: You can apply the Fear and Greed Index to different trading strategies. As noted, the Fear and Greed Index can apply to value, momentum, contrarian, swing trading strategies and more.
Con: The Fear and Greed Index is not predictive. While the options-related elements of the index are intended to be predictive, the underlying data is historic. Sentiment can change quickly, and the index will reflect that change after the fact.
Con: It can be tempting to over-rely on the Fear and Greed Index. The Fear and Greed Index is best used in combination with other research and analysis. As an example, a low index value doesn’t automatically mean that it’s a good time for value investors to buy.
Fear And Greed Index Vs. Other Indicators
One criticism of the Fear and Greed Index is that it’s an average and therefore less precise than individual metrics. Investors looking for more specific sentiment measures may prefer to watch the CBOE Volatility Index (VIX), the put-call ratio and mutual fund flows.
- VIX is unofficially known as the “fear index.” VIX is a component of the Fear and Greed Index. As a reminder, VIX looks at options activity to predict near-term volatility in the S&P 500.
- The put-call ratio is also a component of the Fear and Greed Index. This measure also has a predictive component, since options traders base their activity on their market outlook.
- Mutual fund flows is net money flowing in or out of funds. A net outflow means more investors are pulling money out of mutual and exchange-traded funds—a bearish sign. A net inflow means investors are funneling more money into funds. That typically happens in bull markets and is a sign of investor optimism.
Fear And Greed Index FAQs
What is a high reading on the Fear and Greed Index?
A high reading on the Fear and Greed Index is between 55 and 100. The higher the number, the more aggressively greedy the investing climate.
What is a low reading on the Fear and Greed Index?
A low reading on the Fear and Greed Index is between 0 and 45. The lower the number, the more fearful investors are.
How often is the Fear and Greed Index updated?
The Fear and Greed Index is updated on trading days, as new data for the index elements become available.
Is the Fear and Greed Index an accurate predictor of market movements?
The Fear and Greed Index reflects current market sentiment. It’s not predictive, though very high or low index values can be followed by a reversal.
Can the Fear and Greed Index be used for short-term trading?
Yes, the Fear and Greed Index can be used alongside other analyses in support of a short-term trading strategy. Short-term traders can use the index to validate long or short buying opportunities. Also, when the index reaches extreme lows or extreme highs, it could signal an impending reversal. Short-term traders may want to capitalize on those market swings.
Is the Fear and Greed Index useful for long-term investors?
Yes, the Fear and Greed Index is also useful for long-term investors. For example, fearful investing climates can create good buying opportunities for value investors. Long-term value investor Warren Buffett once famously said he seeks to “be fearful when others are greedy and greedy when others are fearful.”
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