What is the Fear and Greed Index? And How to Implement it as a Trading Strategy

An instrument designed to gauge the sentiment of the market and its investors is the Fear and Greed Index. Its foundation is the idea that human emotions like fear and greed may affect asset values and present opportunities for traders who can recognize them.

The index calculates a score between 0 and 100 using seven indications, with 100 denoting excessive greed and 0 denoting severe fear.

The signs include:

• Volatility: The degree of variation in the prices of an asset over time. High volatility indicates fear, while low volatility indicates greed.
• Market Momentum/Volume: The strength and direction of the price movement and the amount of trading activity. High momentum and volume indicate greed, while low momentum and volume indicate fear.
• Social Media: The level of interest and engagement on platforms like Twitter and Reddit. High social media activity indicates greed, while low social media activity indicates fear.
• Surveys: The opinions of investors and analysts on the market outlook. High optimism indicates greed, while high pessimism indicates fear.

The index is updated daily and can be accessed on CNN for the stock market and on Alternative.me for the cryptocurrency market.

How to Use the Fear and Greed Index as a Trading Strategy

As a contrarian indicator, the Fear and Greed Index can assist traders in determining when the market is overbought or oversold and when to enter or quit a position.

The index states that when the market is experiencing extreme fear, it indicates that investors are too concerned and are selling their assets at a loss. This can be a hint of a good time to purchase since the market might rise again after the anxiety passes.

On the other side, extreme greed in the market occurs when investors are overconfident and are purchasing assets at high prices. Given that the market can correct after the greed subsides, this might be a hint of an opportunity to sell.

The index should not be utilized alone because it is obviously not a failsafe indication. Additionally, traders should take into account their personal objectives and preferences, risk management, and fundamental analysis.

An interesting study for further readings

Gómez-Martínez, R., Medrano-García, M. L., & Prado Román, C. (2023, March 11). CNN Fear and Greed Index as trend signal in global financial markets. SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4384869

According to the above-mentioned study, Gómez-Martínez et al., 2023 argue that it is, in fact, possible to use the FGI indicator as a trading signal. And, in the backtests they conducted, they achieved unbelievable returns. We are definitely suggesting taking a look at it.

Conclusion

The Fear and Greed Index can be a useful tool to complement your trading strategy, but it should not be followed blindly. As always, do your own research and trade responsibly.