Fear and greed are emotions common to human nature, and it is no different in crypto trading. Two terms in crypto trading which best describe these emotions; Fear of Missing Out (FOMO) and Fear Uncertainty and Doubt (FUD). These two terms are related to the way traders react to market news. For instance, FOMO may make traders buy into a coin because they have seen the growth rate and heard the news of its high increase. The result intensifies this greed into buying what they have seen from others. In the case of FUD, traders may sell off or refuse to buy into a coin due to the fear of making a loss following negative circulating news.
So what is the fear and greed index, and how does it affect crypto trading decisions? We will explore all these in this article.
What is the Fear and Greed Index
Primarily, two emotions drive crypto trading, and there is a need to calculate how it functions. According to reports, CNN Money created the Fear and Greed index to calculate the reaction of crypto traders to cryptocurrency price action. This index was initially created for the stock market to estimate how the market is priced. The greed and fear index is calculated in a time frame that measures daily, weekly, monthly, and annual market reactions.
According to the CNN index, extreme fear drives the price below fair market value, and extreme greed drives it above fair market value. The index uses seven indicators and these indicators are measured on a scale from 0 to 100 with a reading below 50 signifying fear and a reading above greed. The seven indicators are;
Junk bond demand
Put and call options
Stock price breadth
Stock price strength
On the other hand, Alternative.me created a Fear and Greed Index for the coin market to measure market reactions. While adopting the same approach as CNN, Alternative.me threw in a new twist by using a different indicator. The fear and greed index is calculated on a scale of 0-100, with 0 representing extreme fear and 100 representing extreme greed. The index is used to indicate investors' bearish or bullish tendencies as well as their social reactions to the crypto market movement.
Crypto Fear and Greed Metrics
Alternative.me provides daily metrics from 0-100 and segments the value into the following category:
0-24: Extreme fear— represented with the orange colour
25-49: Fear—represented with amber/yellow colour
50-74: Greed—represented with light green colour
75-100: Extreme greed—represented with green colour
The above valuation is derived from the index calculating market value using five factors as yardsticks for the current situation. The yardsticks include:
Bitcoin price and dominance
To calculate the market sentiment, 25% of the index is given to the market volatility to measure market uncertainty. The market volume gets another 25% as trading volume is compared to determine if more investors are buying high or low. Social metrics are calculated using 15% of the index with Twitter hashtags indicating interaction with Bitcoin on social media. Also, BTC market dominance is given 10% of the index, measuring the increased market dominance of bitcoin, showing either movement of altcoins into Bitcoin or new investment into the coin. Finally, Google Trends, which collates data from search related to bitcoin search queries, gets 10% of the index. Although survey results get 15%, it has been paused for the moment.
Does the Fear and Greed Index Really Work?
Warren Buffet has advised investors to ‘be fearful when others are greedy and greedy when others are fearful.’ With the Fear and Greed index, traders can at least measure when to take either of the actions advised by the Oracle of Omaha. However, while the Crypto Fear & Greed Index is undoubtedly a tool that can help traders understand the market sentiment, it can often be misleading to rely on it.
For instance, from the graph above, we can see that Bitcoin dropped from $57,500 to about $45,100, losing nearly $12,000 that week. However, within the next two weeks, the price of Bitcoin climbed past $60,000. Despite the severe price movement, the Fear & Greed Index dropped from 94 to 38 from February 22 to March 1. On the other hand, the metrics can also be accurate most times..
Greed and fear are powerful emotions that can drive logical reasoning away when it comes to making crucial decisions. Although there is no way to measure both emotions clearly, it is obvious that they affect human decisions powerfully. The fear and greed index are useful tools but should never be the only tools an investor relies on for making investment decisions. On the other hand, skeptics have criticised the tool for not being an accurate investment tool and claim it is better suited for targeting market entries. For investors targeting the market for low entry points, the Fear and Greed index can be a great indicator for when to buy bitcoin and other crypto. It can also favour investors who flip coins for short-term periods as they can buy the dip and sell high. Whichever way an investor wants to go, it is important to conduct in-depth research independent of the index to determine if it’s buying or selling time. It is also important to have a trading plan so as not to fall prey to the movement of fear or greed on the index.