Introduction
Let’s face it, it is virtually impossible to predict the price movements of cryptocurrency with 100% accuracy. Nonetheless, tools are available for traders use to make a valiant attempt to do just that. The Fear and Greed Index is one of these tools.
The Fear and Greed Index for cryptocurrency operates by generating a single number between 1 and 100. If a value of 1 is generated the Index tells us that the cryptocurrency market will fall as traders are exhibiting extreme fear and are selling their assets. If a value of 100 is generated, the cryptocurrency market is due for a correction and traders are exhibiting extreme greed and are purchasing assets.
So, just how does this Index work?
Extreme fear is present in the market when the Index value is between 0 and 24, and, fear is present when the Index value is more than 24 and less than 50. A generated Index value of 50 demonstrates that the market is neutral. On the other hand, greed is present in the market when the Index value is between 51 and 74, and, any value generated over 74 represents extreme greed.
It must be remembered and stressed that it is emotions which drives the cryptocurrency market. When the market prices are on the rise traders greed kicks into gear and they buy (FOMO - fear of missing out). The contrary exists when market prices are on the decline as traders frequently tend to sell their assets on impulse. [See, Nagoda, K. Managing Fear and Greed in Investment Decisions. (Accessed March 6, 2022)].
How Do You Calculate the Fear and Greed Index for Cryptocurrency?
In calculating the Fear and Greed Index, various signals that influence traders behavior are weighed. These signals include: Google trends, surveys, market momentum, market dominance, social media and market volatility.
- Google trends: examining trending search phrases is a way to assess the amount of greed within the market. By way of example, a high volume of Bitcoin searches indicates greed among traders. From a historical perspective, increases of Bitcoin specific Google querries equates to a high volatility in cryptocurrency prices. Google trends accounts for 10% of the value of the Index.
- Surveys: Surveys that have 2000 participants or more moves the Index value higher as the same demonstrates greedy investors present in the market. Surveys account for 15% of the value of the Index.
- Market momentum: Market momentum reflects the ability of the market to maintain a long-term price trend. Market momentum explores the health and direction of the market. This signal represents 25% of the value of the Index.
- Dominance: Dominance measures the cryptocurrency market dominance with respect to the entire cryptocurrency industry. What this reflects is that when Bitcoin dominance is rising the fewer alternative cryptocurrencies are in play. A drop in Bitcoin dominance is a signal of greed. Dominance accounts for 10% of the value of the Index.
- Social media: Social media aspects such as hashtags, engagement and mentions on several networks are taken into consideration. As social media has become such an integral part of everyday life, it accounts for 15% of the value of the Index.
- Market volatility: Market volatility examines the current price of a cryptocurrency and measures it against price movements of the previous 30 to 90 days. Within the Index, market volatility is utilized as an indicator of fear and accounts for 25% of the value of the Index.
Can an Investor Trade Using the Fear and Greed Index?
The answer to this inquiry is yes and no.
The Fear and Greed Index does not work well for long-term traders as there usually are many repeated rounds of fear and greed exhibited within a long term bull/bear market. The Index rather is used more as a measure of daily market sentiment useful for day and swing traders.
But, although the Fear and Greed Index may prove to be a useful tool:
…it’s only a single data point to help holders and traders alike evaluate the crypto markets with a bit less emotion and a bit more understanding during times of uncertainty. Regardless, all investment models should be considered with a grain of salt and should only be used as another data point to reference – not the sole reason for buying or selling any asset.
[Constantino, T. Crypto Fear Index Shows Most Are Afraid to Buy. Should You Invest Now?. (Accessed March 6, 2022)].
The Fear and Greed Index is solely concerned with market sentiment at the exact moment it portrays. However, as technical and fundamental analysis is devoid of traders’ emotions, they are the preferred methods for evaluation of market movement.
Balancing Fear and Greed for Successful Trading
Inherent volatility in the markets is the base cause for the entry of the emotions of fear and greed to drive investment decisions. During periods of market instability is when investors fall prey to fear and greed as the instability has removed them from their comfort zone. This fear and greed causes irrational decision making often leading to costly investment mistakes.
Clearly, many investors are emotional in thinking and reactionary in action. Fear and greed are able to corrupt the human mind coercing investors to cast aside rationality and control motivating negative changes. For this reason it is of utmost importance to avoid following market sentiment that can be fear or greed driven and stick to investment fundamentals.
While you must remain flexible, your mental state must remain rational when facing changes to your investment decisions. Don’t let the departure from your comfort zone lead you down the irrational path causing the pain of loss.
It is vital for you to stick to rational decisions and fundamentals all while keeping your emotions in check. Avoiding a blind adherence to market sentiment is critical to maintaining your long term investment strategies and finding success in your investment portfolio.
[Nagoda, supra].
Conclusion
So long as it is remembered that the Fear and Greed Index is only one of the evaluation tools available when deciding on investments, it may provide valuable information as to the sentiment of the market at the time of the execution of the trade. Basically, it should not be relied upon as the sole determinative factor in making an investment decision.
It is equally important to keep in mind the role human emotions
play within the markets and the decision making process. In the words of British economist—John Maynard Keynes, ‘The markets can remain irrational longer than you can remain solvent.’
