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How to Use the Fear and Greed Index to Your Advantage

By Inyoung Hwang · May 11, 2021 · 3 minute read

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How to Use the Fear and Greed Index to Your Advantage

CNN’s Fear and Greed Index tries to track which emotion is driving the stock market. The index is based on the premise that fear and greed influence investment behavior, with investors selling shares when they’re scared and buying them when they desire greater profits.

Here’s a closer look at how the Fear and Greed Index (FGI) gets calculated, as well as how investors can use the gauge to inform their investment decisions.

Understanding the Fear and Greed Index

The Fear and Greed Index uses a scale of 0 to 100. The higher the reading, the greedier investors are, with 50 signaling that investors are neutral. To give some historical context, on Sept. 17, 2008, during the height of the financial crisis, the Fear and Greed Index logged a low of 12.

Seven different indicators are used to calculate the Fear and Greed Index.

CNN tracks how much each indicator has veered from its average versus how much it normally veers. Then each indicator is given equal weighting when it comes to the final reading. Here are the seven inputs.

  1. Stock Price Momentum: The S&P 500 versus its 125-day moving average. Looking at the benchmark equity gauge relative to its own history can measure how the index’s 500 companies are getting valued.

  2. Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange. Share prices of public companies can signal whether they’re getting overvalued or undervalued.

  3. Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining. Market breadth can be used to gauge how widespread bullish or bearish sentiment is.

  4. Put and Call Options: The ratio of bullish call options trades versus bearish put options trades. Options give the right not the obligation to buy or sell an asset. Therefore, more trades of calls over puts could indicate investors are feeling optimistic about snapping up shares in the future.

  5. Junk Bond Demand: The spread between yields on investment-grade bonds and junk or high-yield bonds. Bond prices move in the opposite direction of yields. So when yields of higher-quality investment-grade bonds are climbing relative to yields on junkier debt, investors are seeking riskier assets.

  6. Market Volatility: The Cboe Volatility Index, also known as VIX, is designed to track investor expectations for volatility 30 days out. Rising expectations for stock market turbulence could be an indicator of fear.

  7. Safe Haven Demand: The difference in returns from stocks versus Treasures. How much investors are favoring riskier markets like equities versus safer assets like U.S. government bonds can indicate sentiment.

On its website for the Fear and Greed Index, CNN gives a breakdown for how each indicator is faring. For instance, whether each measure is showing Extreme Fear, Fear, Neutral, Greed, or Extreme Greed among investors.
“Stock Price Strength” might be showing Extreme Greed even as “Safe Haven Demand” is signaling Extreme Fear.

Dos and Don’ts of Using the Fear and Greed Index

Why is the Fear and Greed Index useful? For the same reason why it can be helpful to check the temperature of any setting.

Gauging how hot or cold can help determine which move you want to make next as an investor. Are you being too greedy? Too fearful? Is now the time to think about herd mentality?

Also generally, some investors often try to be contrarian, so when markets appear frothy and the rest of the herd appears to be overvaluing assets, investors try to sell, and vice versa.

Recommended: Should I Pull My Money Out of the Stock Market?

Do’s

Use the index to realize that investing can be emotional but it shouldn’t be.

Use it to determine when to enter the market. Let’s say for instance you’ve been monitoring a stock that becomes further undervalued as investor fear rises, that could be a good time to buy the stock.

Recommended: Timing the Stock Market

Don’ts

Don’t only rely on the Fear and Greed Index or other investor sentiment measures as the sole factor in making
investment decisions. Fundamentals–like how much the economy is growing or how quickly companies in your portfolio are growing revenue and earnings–are important.

For instance, the FGI may be signaling extreme greed at some point, with all seven metrics also flashing greed. However, this extreme bullishness may be warranted if the economy is firing on all cylinders, allowing companies to hire and consumers to buy up goods.

Recommended: Using Fundamental Analysis on Stocks

The Takeaway

The Fear and Greed Index is one of many gauges that tracks investor sentiment. Investors generally use it to take a contrarian view of the markets, so when the rest of the herd appears fearful, they buy, or if they’re greedy, they sell. While it can be a useful tool to decide timing on certain investments, it shouldn’t be used as the only determinant in investment decisions.

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Photo credit: iStock/guvendemir


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