Although, it was first introduced as a tool at the Stock Financial Market by calculating price momentum, market volatility, and other indicators by taking an equal weighted average of each of them, it can also be used for Forex and Cryptocurrency markets.
It is designed to capture the level of fear or greed prevailing in the Market at any given time. The index attempts to quantify the emotions and sentiments that drive investor behavior, as these emotions can have significant impact on market movements.
The index ranges from 0 to 100, with extreme fear being associated with lower index’s values and extreme greed with higher values. An Index reading of 0 indicates maximum fear while suggesting that investors are extremely pessimistic about the Market conditions, and they may be selling aggressively. On the other hand, a reading of 100 suggests extreme greed. This is an indication that investors are optimistic about the Market, and they increase their exposure. A 50-level indication is a neutral market sentiment.
One of the biggest advantages of Fear and Greed Index is its simplicity. Many traders can divide the 0-100 zone into quadrants (0-25 level, 25-50 level, 50-75 level, 75-100 level) and apply specific trading plans and strategies for each quarter of the Index.
It is also useful as a Risk Management tool since investors can increase their cash allocation when Markets are trending downwards and increase their respective exposure allocation when the Markets are trending upwards. During a bear market, prices fall, and fear prevails. Following an investment strategy, according to the Index, an investor should increase its cash allocation to protect his/her portfolio. Once there are signs that the Market starts to recover, the strategy will switch from cash to buying power and to take advantage of the rising prices an investor’s exposure will be increased. When the Index reaches extreme levels, it may indicate that a potential reversal in Market sentiment is possible, and the price direction may change.
Taking into consideration the above, the Index can be used for timing Market entries and exits situations. By checking the Index level, a trader may spot a market and a trend reversal and may find a good opportunity to enter the Market.
It is important to note that the Fear and Greed Index is just one tool among many used by investors and traders to analyze the Market(s). It should be used together with other technical and fundamental Market analysis techniques to make investment decisions and not as standalone process.