The emotions of fear and greed play a very important role while investing. When not in control, these can badly impact the decisions of investors. This is where the Fear and Greed Index comes in. It is a powerful investment tool that allows investors to make informed unbiased decisions. In this article, we will discuss how it actually works and what are the factors that affect the rating of FGI. So, without any further ado, let’s begin!
Fear and Greed Index ratings help investors make the right investment decisions.
Understanding the fear and greed index
If you don’t already know, the Fear and Greed Index or simply FGI is an investment analysis tool designed to allow investors to make informed decisions that stand free from emotions of fear or greed. The basic logic behind this index rating is, when the fear is high, it results in the downfall of stocks below their intrinsic value, whereas if the greed is high, stocks trade for much higher than their actual worth. By checking the FGI ratings, investors can make their positions clear and decide if they want to exit or enter the market. Moreover, if you want to know what the FGI rating looks like, then check the market mood index here.
Factors affecting fear and greed index
The FGI is measured on a scale of 0 to 100. Here, 0 represents excessive fear while the value 100 reflects excessive greed. A rating of 50 is considered to be neutral. Suppose, if the reading is 77, it means the greed is extreme and the stock prices will go up. Similarly, if the rating is 35 or 45, it reflects a very high fear.
Below are the factors that affect the Fear and Greed Index rating:
Put and call options
In a generalized way, the put/call ratio measures bullish call options trading volume with respect to bearish put options trading volumes. When the volume of puts is lower and the volume of calls is higher, this factor points towards greed. On the other hand, if the volume of puts is less than the volume of calls options, then this factor points towards fear.
Stock price breadth
Stock price breadth is determined through the declining or advancing volume on the National Stock Exchange. It means, when the volume of stocks rising in price is high, this factor pushes towards greed. On the other hand, when the volume of stocks that are falling in price is high, it reflects fear.
This factor is measured by comparing S&P 500 with its 125-day moving average. If the value of the S&P 500 is greater than its 125-day average value, then this factor goes in the direction of greed. Whereas, if the S&P 500 value is less than the moving average, the factor goes down to fear.
Junk bond demand
This factor is measured by comparing the resulting spread of junk bonds and good investment-grade bonds. When the spread between investment-worthy and junk bonds is higher, it pushes the factor towards fear. On the other hand, when the spread between junk and investment bonds is lower, it pushes towards greed.
This factor is measured by the VIX value, which is a real-time market index that showcases 30-day forward volatility of stock markets. When the value of VIX is higher, it pushes towards fear and when it is lower, it points towards greed.
Stock price strength
Average 52-week highs and lows are used for measuring this factor. When the number of stocks in 52-week highs is higher than the number of stocks in 52-week lows, then the factor points towards greed. And if the number of stocks in 52-weeks lows is higher than the number of stocks in 52-week highs, then it points towards fear.
Safe haven demand
Last but not the least, this factor is measured by measuring the difference between bond returns and the 20-day stock. If the stocks are performing higher than bonds, it represents greed. On the other hand, if the bonds are performing higher than the stocks then, it represents fear.
These are the seven factors that help in establishing the fear and greed index rating, which in turn helps investors in determining the mood of the market. But is it a legit way of analysing the stock market? Let’s find out!
Is fear and greed index a legit market analysis tool?
Fear and Greed Index is a must-have tool in every investor’s toolkit.
The Fear and Greed Index is very useful in providing a general understanding of the market you’re performing in. One of its primary uses for long-term investors is to check if there is a fear rating so that they can buy more shares or double up the quantity of stocks of strong companies. It’s like buying something when the price falls below the original value.
Some skeptics don’t consider the Fear and Greed Index as the right tool because it gauges the timing in the market. Well, there is no doubt that timing the market is not more important than your time in the market, but having the understanding of when or when not to buy more is very very important.
But as we always say, The FGI should never be used alone. It means investors should always use it in conjunction with in-depth research, analysis and due diligence with the companies and ETFs in question. In simple words, this tool adds more value to your stock analysis process.
Do’s and don’ts when using the fear & greed index
When used in the right manner, the FGI can act as a great guide for making profitable investments while protecting yourself from market risks. Below are some dos and don’ts at the time of using the fear and greed index for making investment decisions :
- Use it only to determine the best time to enter or exit the market.
- Plan your investments when the index points towards fear as the prices of stocks are lower this time.
- Explore companies that are undervalued
- Do proper research about companies and ETFs before investing.
- Use FGI for making short term gains
- Invest when the index points towards high greed.
- Abandon stocks before making profits.
Although investors should not try to time the market in order to gain short term gains, the fear and greed index can be very helpful in deciding when to enter or exit the market without causing financial damage to yourself. So, use it wisely and make better decisions.