Fear & Greed In Trading – Tutorial & Explanation

As is well known, investors are driven by two emotions:

  • Fear
  • Greed

These emotions have a marked influence on stock market prices. Too much fear can cause stocks worldwide to fall below the level at which they should be from a fundamental or economic point of view. With greed, exactly the opposite is true. Greed leads to stock prices being pushed too far up.

These two driving emotions are displayed on a scale of 0 (extreme fear) to 100 (extreme greed) on a daily basis.

It is also possible to represent it as a cycle of different market phases. These phases repeat themselves regularly.

With rising prices and corresponding trend movements, greed arises, which ensures that prices continue to rise. This is because the “normal” situation changes in this way and investors become bolder. Courage is followed by euphoria and everyone wants to have as much of the cake as possible. We are now in the final phase of the trend movement. Even our neighbour has increased his position here. But then comes the disappointment. The trend does not continue and the first sales follow. As soon as these accelerate, fear sets in and pessimism follows at the low point. Here often the last ones have sold their shares again. But then the cycle starts all over again…

The calculation of the Fear & Greed Index

The Fear & Greed Index is calculated from 7 indicators.

For each indicator it is examined how far it deviates from its average. This is then compared to how far it normally deviates from the average. Each indicator is considered here on a scale from 0 to 100. The higher the value, the greedier the investors are. A value of 50 is neutral.

All indicators are then combined and equally weighted to produce a final index value.

These 7 indicators are as follows:

  • Put and Call Options
  • market volatility
  • stock price strength
  • Safe Haven Demand
  • market momentum
  • Stock Price Breadth
  • junk bond demand

Put and Call Options – The Put/Call ratio

This indicator compares the trading volume of put options with the trading volume of call options. It thus indicates the ratio of traded put options to call options.

In recent weeks, the put/call ratio has risen to one of the highest levels in the last two years, indicating extreme fear.

This rating was changed from “fear” to “extreme fear” on February 20, 2020.

The history of the Put/Call Ratio can be viewed here: Put/Call Ratio History

Market Volatility – The Market Volatility

This indicator measures the fluctuation margin or volatility of the market. The Volatility Index (VIX) is used for this purpose, which shows the expected fluctuation margin of the US S&P 500 share index.

This currently stands at 79.37 and indicates that investors are still concerned about declines in the stock market. The “fear” rating was changed to the current “extreme fear” rating on February 21, 2020.

In Germany, the VDAX is used to measure volatility. The DAX volatility index (VDAX) expressed the fluctuation range of the DAX share index expected by the futures market.

Stock Price Strength – The strength of the stock market

Stock market strength is the ratio of stocks reaching new 52 weekly highs and lows on the New York Stock Exchange (NYSE).

This indicator also indicates extreme fear at the moment. This is because the number of stocks that have reached a fresh 52-week low exceeds the number of highs and is also at the lower end of the range.

The ranking was changed here on 27.02.2020 from “fear” to “extreme fear”.

Safe Haven Demand – The demand for safe havens

This is where the difference between the yields of shares and government bonds is calculated.

Over the last 20 trading days, bonds have outperformed equities by 30.40 percentage points. This is almost the weakest performance of equities compared to bonds in the last two years. This suggests that investors are fleeing from equities into bonds for security reasons.

The ranking was changed from “fear” to “extreme fear” on 19.02.2020.

Market Momentum – The momentum of the market

It measures the momentum of stock prices from the S&P 500 Index (SPX) against its 125-day moving average.

Currently, the S&P 500 is around 20.70% below its 125-day moving average. In the last two years, it has generally been above this average, so that a rapid decline and thus an extreme degree of fear can be seen here.

The ranking “extreme anxiety” was achieved on 04.03.2020. Before that the ranking was “fear”.

Stock Price Breadth – The stock price breadth

This indicator shows the ratio of the share volume of rising shares to falling shares. The indicator used for this is the McClellan Volume Summation Index. You can find more information about this indicator here.

In the last month, a daily volume 28.51% higher was measured in declining stocks than in rising stocks. The indicator here is at the lower end of the range of the last two years.

The “fear” rating was replaced by the “extreme fear” rating on 21.02.2020.

Junk Bond Demand – The demand for junk bonds

This measures the spread between the yields of investment grade bonds and so-called junk bonds.

At present, investors in junk bonds are demanding 2.27 percentage points additional yield compared to investment grade bonds. Investment-grade bonds are bonds of best to medium credit quality. Historically, this spread, while low, has been significantly higher than recent levels, suggesting that investors have become more risk-averse.

The “extreme fear” ranking was issued here on 26.02.2020. Previously, the ranking was “fear”.

The development of the Fear & Greed Index over time

When the S&P 500 (SPX) fell to a three-year low on 17 September 2008 – the peak of the financial crisis – the index for fear and greed fell to 12, the index gained some ground and reached 28 before the shares bottomed out on 9 March 2009 and the recent bull market began.

You can see here that the index is a good indicator of the respective highs and lows of the S&P Index.

When did the Fear & Greed Index last trade at 1?

The Fear & Greed Index last traded at the extreme point of 1 on 12.03.2020.

On 12.03.2020, the US stock index Dow Jones continued to plunge unchecked in the face of the coronavirus crisis. The index lost just under ten percent and thus recorded the most severe slump in 33 years. The loss was around 2350 points and stood at around 21,200 points after the close of trading. The Nasdaq technology index and the leading index S&P 500 suffered losses of almost the same magnitude.

Conclusion on the Fear & Greed Index

It is not for nothing that the Fear & Greed Index is highly regarded and provides a quick and comprehensive insight into the current prevailing emotion in the market.

If there is extreme fear in the market, one should free oneself and wait patiently for possible buying prices. As soon as the index falls below 18, one can often expect to see the first bottom.

Extreme greed should call for caution and further purchases should be well considered. A value above 90 can be a good indicator for a possible top formation.

However, one should simply not blindly buy or sell here. This index, like any other indicator, is only a tool and can provide additional information.

In addition, the index is available free of charge and is updated daily. Especially in phases of an exaggeration, one should not let the index out of sight.

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