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Crypto Fear and Greed Index: What It Is and How It Works

4.7
| by
Daniel Lew
-

The Fear and Greed Index was originally developed by CNNMoney for the stock market. CNN takes a balanced approach by assigning equal weights for the indicators it uses. For example, each indicator is given a 14.2% weight.

The seven indicators used are junk bond demand, market momentum, market volatility, put and call options, safe-haven demand, stock price breadth, and stock price strength. These indicators measure different elements of how the stock market is behaving at the present moment.

To calculate this index, CNN looks at how far each indicator has deviated from its average compared to how far it regularly deviates. They are then individually scored on a scale of 0 – 100. The indicators are put together to create the final index. The higher the score, the greedier inventors are at the moment.

What is the Crypto Fear and Greed Index?

The Fear and Greed Index is used to measure investors’ sentiments towards the markets. This index reveals whether the markets are bullish or bearish, and it is constructed based on two opposing emotions, fear and greed. 

Investors can be irrational when there are extreme market conditions. For instance, investors are fearful when the market is depressed and greedy when the market is bubbly. Understanding investors’ emotions present an opportunity for investors to take advantage. As the famous investor Warren Buffett says, “Be fearful when others are greedy and greedy when others are fearful.”

How is the Crypto Fear and Greed Index Calculated?

Alternative.me adapted CNN’s approach and developed a fear and greed index for Bitcoin. The concepts are fundamentally the same, but the indicators used are different. The reason for using bitcoin is because it currently has the largest dominance (over a third of the entire cryptocurrency market cap). As a result, the Bitcoin Fear and Greed Index is the most popular and important one in the space. This index is a potential method to identify investor behavior towards Bitcoin and can be loosely applied to cryptocurrencies in general.

The index is scored from 0 – 100. 0 indicates extreme fear where investors are overly bearish on the outlook of Bitcoin. 100 indicates extreme greed where investors are overly bullish. This index can be used as a signal to mark the top and bottom of crypto’s market cycles.

Historical fear and greed index.

The Crypto Fear & Greed Index looks at six indicators. The indicators in this index are created from a mixture of quantitative and qualitative measures.

1. Volatility (25%)

Volatility compares Bitcoin’s current volatility and its maximum drawdown to its average values from the last 30 and 90 days. When there is a sharp rise in volatility, this might indicate that the market is fearful. 

2. Market Momentum/Volume (25%)

Market momentum combines Bitcoin’s current market volume and market momentum and compares it to the average of the last 30 and 90 days. When upward momentum is strong, this might indicate a bullish market.

3. Social Media (15%)

The social media indicator uses sentiment analysis computed from likes, posts, hashtags from Twitter. If the measured interactions increase sharply over a short period, the market might be greedy.

4. Dominance (10%)

Dominance measures how much market capitalization Bitcoin takes up from the share of the entire cryptocurrency market capitalization. The larger the Bitcoin dominance, the less speculation there is for altcoins, which might signify bearishness among investors. 

5. Trends (10%)

Trends looks at Google search trends for Bitcoin-related terms. It considers search volumes and recommendations from popular sites. 

6. Surveys (15%) - Currently paused

Weekly surveys are conducted on a polling platform to see what individuals are thinking of the markets. 

Each of the indicators above comprises scores from volatility and market momentum, while the rest is from the qualitative scores. Although the Bitcoin Fear and Greed index differs from the original Fear & Greed index, both indices fundamentally measure our emotions towards the markets. Investors can utilize this index to inform them of how the markets are doing.

How Relevant is the Fear and Greed Index?

The crypto market is a field of emotions, majorly fear and greed. Periodic spikes in sentiments translate into a manifestation of investor emotions and behaviors. Triggers of these emotions could be as big as a national financial report and as trivial as a single social media post. Effects could spread across the general market or be localized to a few assets in the market. 

Investors get greedy when they predict favorable market conditions and fearful when the prevailing conditions are not promising for the crypto market. Fear of missing out (FOMO), depending on the intensity of positive events and speculations around the market, investors flock to the market, buying into promising assets and holding on to them in expectation of even more gains. In situations like this, the buying force overpowers the selling.

The reverse is the case when the market appears to be going for a deep dive. Investors are vulnerable to panic selling or panic buying, influenced by market sentiments.

With the Fear and Greed Index, investors get an idea of how other investors feel about the market and make their decisions using the information derived from the data. Individual decisions could differ anyways. While certain investors move with the market, others might decide to ‘get greedy when others are fearful’. Nevertheless, the Fear and Greed Index simplifies this process and saves investors the resources required to make this research on their own.

How Reliable is the Fear and Greed Index? 

The Fear and Greed Index has shown impressive accuracy over the years, this is as regards its ability to correctly represent investors’ sentiments in figures and scales. The accuracy of the index in terms of price development depends majorly on the reaction of investors to the data provided by the index. Hence, fear and greed emotions have a strong correlation with price development.

Historical statistics show that Fear and Greed index’s values drop (fear) when the asset values drop and grow when there is an appreciation in the values of assets. This direct correlation is prone to variations, but this doesn’t necessarily reflect the accuracy of the index itself as the Fear and Greed Index only measures the market sentiments and not how it correlates with the value of crypto assets. These two phenomena (market sentiments and value of crypto assets) should be treated as ‘separate’ when measuring the reliability of the Fear and Greed Index.

Applying The Fear and Greed Index in Investing

Although investors are generally more interested in bitcoin’s Fear and Greed Index, there are high chances of sentiments varying across assets. Investors using the Fear and Greed Index should make a number of considerations, including; 

Asset of interest

Bitcoin dominates the cryptocurrency space and dictates the movement of other assets to some extent. However, there are frequent cases of assets moving against bitcoin. Depending on the sentiments of the crypto community towards a particular asset, it could continue to go up even when bitcoin and the majority of crypto assets see a drop in value and sentiments. 

Unfortunately, the Fear and Greed Index metrics aren’t available for many assets. When available, this should be considered alongside that of bitcoin and any other asset that affects the concerned project. Relying solely on fear and greed metrics might lead to making wrong decisions.

Duration of investment

The Fear and Greed Index might be more relevant in the short term. Investors who trade on a shorter-term timeframe should consider the periodic variation in general market sentiments before trading their assets or marking a purchase. 

Short-term changes in values and sentiments might be irrelevant if you intend to hold on to your investments for a long period. Long-term investors should prioritize the project’s fundamentals over what the index suggests.

Other prevailing conditions

Market sentiments can be offset by several factors and steer values in a different direction. These factors might be outside the considerations of the Fear and Greed Index. Projects with a strong volatility control scheme can mitigate the effect of panic sales and even maintain an upward trend while the sentiments are low; an opposite scenario might occur when a project’s tokenomics isn’t really solid. These should be considered alongside the Fear and Greed Index values.

Final Thoughts

The equity and crypto markets are volatile, and no single measure can accurately gauge them. An investor should always use a holistic combination of market metrics when making decisions.

Experienced investors harness this fluctuation in sentiments and utilize it in several ways which include putting their own emotions under control. Panic buying and panic selling could result in grave losses or missing out on tangible gains.

Relative to any other investment space, emotions run fastest in the crypto space. This is responsible for the undue volatility the space is known for, it is hard to control your emotions in an environment like this, but it is vital to your success as an investor or trader. Instead of falling prey to your own emotions, learn to study the situation and make well-planned decisions using information gathered from your study and your past experiences.

The Fear and Greed index should not be the only indicator used when making conclusions on the directions of the markets. John Maynard Keynes, a famous economist, once said, “The stock market can remain irrational longer than you can remain solvent.” Do be mindful of this quote and stay safe trading the markets!

To learn more about the markets, check out the following articles:

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Daniel Lew
Daniel Lew
Daniel is enthusiastic about data and technology and is currently exploring blockchains.

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