In the world of investing, psychological influence is prevalent and inflicts shifts in stock prices. The financial market is on the same table, where sentiments of the investors play a crucial role and alter the tendency of the entire market in one go. In the stock market, fear and greed are omnipresent. When fear dominates, investors look for securing their funds and avoid loss. On the contrary, when greed prevails, investors look to maximise their profits. Here, the fear and greed index comes into the picture to measure the emotions and guide traders to take an optimum decision. Let’s delve deep to comprehend more about it.
Meaning of Fear and Greed Index
Fear and Greed Index (FGI) is a comprehensive tool to measure the sentiments of the investors on a daily, weekly, monthly or annually. Fear and Greed are two prominent emotions that create volatility in the stock market.
In principle, the index may be used to assess whether the stock market is reasonably priced in accordance with the investor’s emotions. This is primarily based on the perception that excessive fear tends to power down share prices, while irrational greed cultivates the opposite effect. In a financial context, it assesses whether the investors are too bullish or bearish for a stipulated period on the stock market. The range of FGI starts from 0 (drastic fear) to 100 (extreme greed). Let’s check out its aggregate rating:
- 0 to 49 reflects fear
- 50 indicates neutral
- 51 to 100 reflects greed
Emotions in the financial market act as deterrence to a rational decision.
How sentiments drive the financial market?
Generally, if you see a stock chart, you will come across a major variation in the price tendency with highs and lows. On frequent occasions, these fluctuations don’t correspond with the essential transitions in the economy, corporate policies or any relevant government reforms. Hence, increasing volatility indicates the sign of the sentiments that drive the prospects of the market.
Consequently, most investors use the fear and greed index to assess the market condition. It assists them to make prudent decisions and stand apart from the league. Fear in the financial market plays a crucial role in the decision-making process of investors. If fear prevails, it reduces the stock prices and investors initiate pulling their capital out of the market. On the flip side, whilst greed thrives, investors put their money in the market massively by buying assets. So, investor’s sentiments are an indispensable part of the financial market. If required, you can check market mood index to make a skillful decision.
7 essential components of Fear and Greed Index
The FGI is based on the composition of seven essential elements that come collectively to shape the final rating. The final score ranges from 0 to 1 i.e from drastic fear to excessive greed. Let’s comprehend these seven components:
- Stock Price Strength: The statistical ratio represents the number of total stocks listed on the BSE (Bombay Stock Exchange) and NSE (National Stock Exchange) scaling 52 weeks high in evaluation to 52 weeks low. The 52 weeks high reflects confidence or greed, while 52 weeks low amounts to fear.
- Market Momentum: It is measured by comparing the BSE or NSE index level with the moving aggregate of the index for a specific period. Further, if the index is underneath the moving aggregate, fear is supreme. On the contrary, if the index is nicely above the median, greed is dominant.
- Stock Price Breadth: The buying and selling volumes of rising stocks pertinent to fall off stocks at the BSE or NSE. Increase trading volumes in rising stocks, as opposed to declining stocks, imply greed and vice versa.
- Safe Haven Demand: When fear prevails in the market, investors expect the price to fall and attempt to get their capital out of the stock market and right into secure funding i.e bonds.
- Junk Bond Demand: This component signifies that the intended investors are prepared to embrace high-risk tactics or not. For example, when greed is supreme, there is a huge surge in the junk bonds that reflects investors are more solicitous with yield compared to risk.
- Put and Call Options: It is the metrics between call options and puts options. In general, call options signify a bullish trend (greed), whereas put options reflect a bearish trend (fear). If the trading volume is towering for put options, it implies that fear has prevailed. On the flip side, if the trading volume falls behind put options and call options prevail, it amounts to uprising greed.
- Market Volatility: It is used to measure the price fluctuation of the stock, which is popularly called VIX and helps to measure the stock market’s volatility for a specific period. A higher level of volatility indicates greater fear in the market and a lower level of volatility reflects rising greed.
Fear and greed are the most prominent and quite often used terms in the realm of investing. It reflects a persistent cycle of sentiments that influences the trading activity in the financial markets. When the market stands neutral or free from sentiments, only then one can make a rational decision.
