It would be wrong to consider that everything is logical in financial markets. On the contrary, erratic price movements are a daily occurrence, and the greater the momentum the price gets, the more unstable and unpredictable the market can become. Like all human beings, investors are prone to emotional decisions, and the most prevalent emotions in financial markets are fear and greed.
With years, market researchers learned to measure how these two emotions affect the markets, and so they created the fear and greed index. The post’s scope is to analyze what it is and how it works.
What is the fear and greed index?
The fear and greed index attempts to measure the overall market sentiment. It helps to determine whether a given market is overpriced or undervalued. When the trend is bullish, investors become overly optimistic and greedy, causing the price to soar even higher. On the other hand, sceptical investors, bad press, or regulatory pressure cause bear trends. In bearish trends fear permeates the market, causing investors to close their positions with the hopes that they beat the market from bottoming out.
Such erratic behavior can lead to extremities when investors throw their common sense out of the window and start gambling on the market. Colossal price swings at market tops and bottoms will reflect that. Ultimately, the fear and greed index aims to define which state the market is in at any given moment.
CNNMoney developed the index to estimate how prevalent emotions of greed and fear influence stock market behavior and its state. Alternative.me introduced and adapted the index for the crypto market.
How does the fear and greed index work?
Source: Alternative.me
The crypto fear and greed index has a meter that ranges from 0 to 100. 0 means extreme fear, while 100 indicates excessive greed. Such extreme readings have never been reached yet.
If the score is close to 0, it means that fear dominates the market, and sellers (bears) control it, and the prices keep on falling. The red color marks the fear index. The closer the score gets to 0, the higher the possibility of a correction or even a trend reversal from bearish to bullish.
A score closer to 100 means that greed dominates the market and buyers control it. As a result, prices keep rising. The closer the score gets to 100, the higher the possibility of a correction or even a trend reversal. The score is in green color.
Fear and greed levels differ in their intensity. A score between 0 and 24 is considered ‘extreme fear’. A 25-49 score indicates that ‘fear’ dominates in the market. A 50 score means the market is in neutral territory, and there’s no bias. 51-74 indicates that the market runs on ‘greed’, and the readings of 75 to 100 refer to ‘extreme greed’ dominating the crypto market.
The blocks that comprise the fear and greed index
Alternate.me includes five components into their fear and greed index. The five are volatility, market momentum/volume, social media, dominance, and trends. It used to be six, but surveys (the sixth one) are paused at the moment.
Volatility
Volatility comprises 25% of the index data. The current volatility is calculated based on the maximum drawdowns of bitcoin and contrasts them with the averages of 30 and 90 days. An increase in high volumes indicates the market is in a state of fear and overrun by sellers.
Market Momentum/volume
Market momentum and volume comprise another 25% of the index data. These two are also compared to the averages of 30/90 days. When the buying volumes increase in a buoyant market daily, it might mean the market is extremely bullish or in a state of greed.
Social media
Social media comprises 15% of the index data. The company thoroughly analyses Twitter hashtags connected to the most popular crypto coins (though they only show for bitcoin on the website) and then computes how many interactions from platform users they get with the themes and at what time intervals. Elevated interaction on the topics and increasing interest in specific coins equals a greedy market phase.
Dominance
Crypto market dominance comprises 10% of the index data. As bitcoin has become a haven in the crypto market, its dominance shows whether fear or greed dominate. When bitcoin’s dominance grows, it shows that the market is in a state of fear. When the dominance decreases, investors rush to various altcoins, which indicates that the market is in a state of greed.
Trends
Google data trends comprise 10% of the index data. The company uses data trends, especially bitcoin, to evaluate how much the search volume for specific terms changes within a particular period. The rise in specific terms may show both fear and greed dominated market. It all depends on the psychological aspect of the search. An increase in ‘bitcoin market manipulation’ phrase search could mean the market is in a state of fear, while an increase in the phrase ‘buy bitcoin’ could mean greed inspired market.
Can you trust the index?
The fear and greed index is a helpful tool that you can add to your research arsenal. However, you should not base your investment decisions on the data that is purely derived from the index. Include both fundamental and technical analysis to make a more informed decision.
Likewise, the index should not be used as a prediction tool but rather an assessment that you should supplement with other technical and fundamental tools and indicators.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
