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Investors are always trying to avoid losses and to do so, they often take risks or implement various strategies. If you are a beginner investor and you are also unsure about how to safely invest in the stock market without drowning in losses, using the Fear and Greed Index or FGI can come in very handy for you.

Fear and Greed Index is a popular tool that is ideal for those who are thinking of entering the stock market but cannot decide the right time to do so. The FGI tool will provide you with the current status of the stock market depending upon the emotions of the other investors.

This makes it easy for you to decide whether you should buy stocks or sell them at a given time. If you are interested in knowing more about the index, keep reading.

What does the Fear and Greed Index (FGI) Exactly Mean?

Developed by CNNMoney, the Fear and Greed Index (FGI) is used to measure emotions of fear and greed among the investors as these emotions are the primary emotions that are known to have an effect on the investors when buying stocks.

FGI gauges these two emotions on a daily, weekly, monthly, and yearly basis, and it ranges from 0 (extreme fear) to 100 (extreme greed). The index is used to check if the prices of the stock market are fair or not, and the reasoning behind it is that too much fear can result in low stock prices, and excessive greed can result in high stock prices.

According to the current market sentiment, the fear and greed index is 100% invested in stocks and holding 0% cash, and the index value is 59, which means that the market is leaning towards greed.

Key Points

The Fear and Greed Index is developed by CNNMoney. It is a tool designed to measure two of the primary emotions of investors in the stock market.

The tool is based on the logic that immense fear can lower stock prices, and immense greed can increase the stock prices.

There are 7 major factors utilized by CNN to produce a number anywhere between 0 and 100 on the Fear and Greed Index that tells how much fear and greed can be found in the stock market during a given period of time.

Understanding the Fear and Greed Index

As mentioned earlier, the Fear and Greed Index is used to check whether the stock market is fairly priced or not according to the driving emotions of the investors. Investors normally sell their stock holdings when they are too afraid, which results in the falling of stock prices, maybe even to the point of below intrinsic value.

On the other hand, when the investors are greedy, they keep on buying stocks, thereby increasing the prices. This is how the Fear and Greed Index uses the emotions of fear and greed to tell the investors when to buy or sell stocks. Let's take a look at the Fear and Greed Index ratings and what do they mean:

when the rating ranges between 0 to 49 - Fear

when the rating is 50 - Neutral

when the rating falls between 51 to 100 - Greed

Some believe that the FGI tool is far from a proper investment tool as it enables the investors to time the market for scoring short-term profits rather than buying and holding stocks for a longer duration.

Such people are not entirely wrong, as investors should eschew trying to use a market timing strategy, but it is great for investors who are looking to enter the market but cannot choose the right time to do so.

How does it Work? 7 Factors in Calculating FGI

The Fear and Greed Index is calculated by utilizing 7 different factors, which establishes how much fear and greed are dominating the stock market. These factors are measured between 0 to 100 and then equally weighted to produce the Fear and Greed Index value. Here are the 7 factors that produce the FGI value:

1. Stock Price Strength

This refers to the number of stocks on the New York Stock Exchange (NYSE) hitting 52-week highs versus the number of stocks hitting 52-week lows.

2. Stock Price Breadth

This refers to analyzing trading volumes in rising stocks with respect to declining stocks on NYSE, and it indicates greed if the trading volumes in rising stocks are higher against declining stocks and vice-versa.

3. Stock Price Momentum

Stock Price Momentum or Market Momentum refers to analyzing the performance of the S&P 500 against its 125-day moving average (MA), and a greater relative performance indicates greed and vice-versa.

4. Junk Bond Demand

The yield spread between junk bonds and investment-grade bonds is called junk bond demand, and a higher junk bond demand indicates fear and vice-versa.

5. Put and Call Options

This refers to measuring the put options against call options. If they lag behind the call options, it indicates greed, and if the put options surpass call options, then it signifies fear.

6. Safe-Haven Demand

Safe Haven Demand means analyzing the performance of stocks relative to bonds, and the thing to remember is that higher relative performance indicates greed and vice-versa.

7. Market Volatility

Market Volatility is measured by CNN through the Chicago Board Options Exchange's Volatility Index (VIX), and a greater VIX value means fear and vice-versa.

What are the Advantages and Disadvantages of the Fear and Greed Index?

The Fear and Greed Index is a really popular tool used by millions of investors all around the world to gauge the emotions of the stock market at a given time. You also might be planning to employ it to help you with your stock investment.

But before you start relying on it too heavily, you must be made aware of the full picture of the index, including its advantages and disadvantages.

Advantages of FGI

Many academics believe that, like love, greed plays a great role in influencing human minds to perform actions illogically even though there is no definite researched proof on the subject. When it comes to money, fear and greed are two of the primary motives found in human beings.

In the world of the stock market, there are many investors that let these two emotions of fear and greed overpower them when buying stocks. This has been observed by behavioral economists, and there also has been a lot of evidence supporting such behavior. Let's take a look at some cases that show that FGI can indeed indicate a turn in equity markets:

On September 17, 2008, the Fear and Greed Index was as low as 12 after the Lehman Brothers went bankrupt, insurance company AIG almost collapsed, and the S&P 500 fell to a three-year low.

In September of 2012, on the other hand, the index soared over 90 when the Federal Reserve (FED) announced the third round of quantitative easing (QE3), and the equities all over the world rebounded.

Therefore, this evidence suggests that the Fear and Greed Index can indeed come in handy for making investment decisions, and investors should buy stocks when the index indicates fear, and when it indicates greed, they should refrain from spending on the stock market as the stocks may be overpriced.

Disadvantages of FGI

Fear and Greed Index encourages market-timing strategy among the investors, which, as argued by many, is not an appropriate strategy for investing in the stock market.

The buy-and-hold strategy is considered a better and more practical strategy because the market-timing strategy enables investors to frequently trade in and out of stocks which results in less favorable returns in the long run.

Relationship of Behavioral Finance and FGI

A significant amount of research has been conducted in the field of behavioral finance and FGI; that is, the Fear and Greed Index can be linked to this field. Due to this link, this tool gained a lot of credibilities.

In this area of study, in 1979, two psychologists, Daniel Kahneman and Amos Tversky came with a theory called 'prospect theory'. According to the said theory, one person can be both risk-taking and risk-avoiding as it depends on whether a certain decision is more likely to result in a profit or a loss.

As investors generally want to avoid a loss more than anything, they tend to take more risks to avoid a loss rather than take more risk to obtain a profit. This behavior is the primary basis of the Fear and Greed Index, especially when it leans towards fear.

Using the Fear and Greed Index

A question that may arise in your mind is how exactly can you use the Fear and Greed Index when investing in the stock market. We have an answer for you, which is that you can use the FGI tool to correctly time your entry into the stock market.

This makes the index more of a market-timing tool than an investment research tool and runs on the logic presented by Warren Buffet in his famous quote, "Be fearful when others are greedy, and greedy when others are fearful."

For instance, as an investor, you should sell your stock holdings if the index hits a value of 90 or more as it means that the stock prices may have skyrocketed, and it will make you a profit if you sell your stocks at this time.

Additional Tips

Your investment entry should be when the index leans towards fear.

Look out for companies that are undervalued.

Don't use the index for short-term profits.

Do not invest in the market when the index leans towards greed.

You must not dump stocks too soon before you can make a good profit.

Frequently Asked Questions

Question: What is meant by overreaction?

Answer: An overreaction refers to an emotional response that is caused by news about security, is primarily led by greed or fear, and results in becoming oversold or overbought.

Question: What is the State Street Investor Confidence Index, and what is it used for?

Answer: The State Street Investor Confidence Index is used to measure the confidence of the investors by analyzing the risk taken by institutional investors.

Question: What does CBOE Nasdaq Volatility Index do?

Answer: The CBOE Nasdaq Volatility Index (VXN) is used to keep tabs on how volatile the Nasdaq 100 index can be.

Question: What is meant by Market Dynamics?

Answer: When the supply and demand for certain products and services change, the pricing signals resulting from them are referred to as Market Dynamics.

Question: What is a Sentiment Indicator?

Answer: A Sentiment Indicator is a graphical or numerical indicator that is used for presenting the feelings of a group towards the market or economy.

Conclusion

This article was meant to inform you of all the details regarding the Fear and Greed Index (FGI), and we hope it was successful in doing so.

As an investor, it is essential to know about all the basic strategies and tools of the stock market, and the FGI tool will certainly prove to be useful, especially if you are not an experienced investor.

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Fear and Greed Index - Overview, Calculation, Example

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Investors are always trying to avoid losses and to do so, they often take risks or implement various strategies. If you are a beginner investor and you are also unsure about how to safely invest in the stock market without drowning in losses, using the Fear and Greed Index or FGI can come in very [...]