It is clear that emotions play a vital role when making investment decisions. Based on certain emotions, at times, investors use intuitions to make trading decisions. This is a reason why crypto analysts advise investors to create practical investment plans and stick to them to avoid making impulsive crypto buying and selling decisions.
Now, the crypto and stock market have developed sentiment indicators that gauge the level of emotions the market attaches to security or cryptocurrency. Market sentiment indicators aggregate data to determine the feelings and thoughts of market participants. Let’s explore one of these indicators, the Fear and Greed Index, and find out how it helps in making investment decisions.
What is the Fear and Greed Index?
CNN Business developed the Fear and Greed index to capture the sentiments of the market towards a specific security such as the Dow Industrial Index. Basically, CNN Business designed this index for the stock market. Later on, Alternative.me developed a Fear and Grid Index for the cryptocurrency sector. To better predict the performance of cryptocurrencies, Alternative.me uses six factors to determine the thoughts and feelings crypto users have towards a specific cryptocurrency or the entire market.
The fear and greed index (FCI) is a sentimental analysis tool for gauging market conditions related to an investment asset or a group of related securities. Basically, this indicator measures the level of fear and greed that exist in the market. It shows daily, weekly, monthly and yearly changes in market sentiment. The most suitable market sentiment tool for the crypto sector is the Fear and Greed Index developed by Alternative.me.
Fear and Greed
For now, we need to understand what fear and greed mean when we refer to the cryptocurrency sector. Fear refers to the negative feelings that spread among crypto users when the market is bearish or when there is bad news.
Analysts associate fear in the market with corrections, bear momentum and market bottoms. In these circumstances, many investors tend to sell their holdings in large amounts irrespective of the prevailing market price.
Greed means the positive sentiments that spread among crypto users which influence them to buy more of a cryptocurrency without much consideration of its fundamentals. The market considers rising prices as a sign of continued bullish momentum.
In most cases, the prices of the cryptocurrency will rise until there is little or no more buying power in the market. We associate greed with irrational optimism which results in a market bubble.
How the Fear and Greed Index works
The Fear and Greed Index has a range of between 0 and 100 which indicates different levels of the two emotions. The range 0 to 49 indicates fear while 51 to 100 shows greed. Incidentally, the middle figure, 50, shows a neutral state in terms of emotions. There is neither fear nor greed.
In other words, 0 to 49 shows that a cryptocurrency is undervalued while 51 to 100 means that it is overvalued. These broad ranges representing fear and greed are further divided into fear, extreme fear, greed, and extreme greed.
0–24 = Extreme Fear
25–49 = Fear
50–74 = Greed
75–100 = Extreme Greed
Calculating the Fear and Greed Index
There are six weighted factors that determine the level of fear or greed in the market.
?? Volatility (25%): The index measures upward and downward swings in the price of a cryptocurrency and compares that to the 30-day or 90-day averages. High volatility in the market means there is fear.
?? Momentum/volume (25%): This instrument measures changes in the volume of an asset and compares that with the 30-day and 90-day averages. If the trading volume is high it means that many traders are participating in the market, thereby increasing the index.
?? Social media (15%): The indicator tracks the number of mentions of a cryptocurrency on Twitter to determine the level of interest in it. Mainly, it aggregates the number of hashtags related to a cryptocurrency such as BTC and compares that to the 30-day and 90-day average mentions. More mentions of hashtags and cryptocurrency increase the index.
?? Surveys (15%): The index conducts market-wide surveys to find the users’ perceptions of a cryptocurrency. If the results show enthusiasm for the cryptocurrency or market the index increases.
?? Bitcoin dominance (10%): This is a percentage of the Bitcoin’s market capitalization against the total crypto market cap. If the Bitcoin dominance is higher than before, that signifies an increase in uncertainty in the market. This is because investors will be shifting their resources to altcoins.
?? Google Trends (10%): The indicator tracks the number of searches of specific terms in the Google search engine. For example, when the volume of search terms related to Bitcoin is high, it indicates a greater interest in it than before. In the past, an increase in BTC Google-related searches correlated with an increase in its price volatility.
Using the Fear and Greed Indicator to Predict Price Movements
The value of the index can show the direction the price of the cryptocurrency is likely to take. It can indicate a possible price rise, a price fall, or a constant one. Investors can find the latest cryptocurrency prices at Gate.io.
The Index enables traders to predict possible price reversals. For instance, if the reading is within the extreme fear territory it is a sign that the price will soon rise. In this case, the reading between 0–24 shows that the price has a high possibility of increase in the near future.
Conversely, if the reading of the Index is within the extreme greed category, it is a sign that the prices are likely to fall soon. However, the indicator does not tell how high the prices will rise.
Using the index to make investment decisions
The crypto Fear and Greed Indicator helps investors to decide when to buy or sell a cryptocurrency. For example, if the index is falling, it means there are risks in the market. In this case, an investor may relocate his/her funds to safer havens such as gold. In the crypto sector, others may need to buy stablecoins to maintain their net worth.
If the market is extremely fearful, it can be a good sign for investors to buy the dip and hold, waiting for appreciation of the asset. In the event that the cryptocurrency’s price rises, the investment will generate a profit.
On the contrary, extreme greed shows a potential for a price reversal. In this case, there is a high possibility for the price of the asset to fall. Therefore, it is a good sign to sell the asset.
Conclusion
The Fear and Greed Index is an essential market sentiment indicator. Investors can predict when prices may fall and when they may rise. Usually, traders sell their cryptocurrencies when the market is extremely greedy. When the market is fearful, they can buy and hold in anticipation of future price increases.
