It’s well known that markets are driven by emotions, despite the best efforts of traders to be as rational as possible. The two main ones are fear and greed. Investors are afraid of losing money, and they are greedy about making money. Depending on which sentiment wins out, the market will either go up or down.
CNN Business developed an index to measure how much these emotions influence the stock market. It can also measure market trends, based on the idea that if markets are overtaken by fear they will fall; and if markets are greedy, they will rise. Not everyone subscribes to the validity of the tool, but it is still often used in investment research and as a barometer for market timing.
How does it work?
The Fear and Greed index has been a fairly reliable indicator of market shifts in equity markets. It falls to lows when the market is trending downward in the wake of a major economic turn, such as the 2008 subprime market. Conversely, It also rises to highs as markets are moving upwards, such as at the start of the pandemic recovery.
The index uses seven different indicators and then averages them out to generate a scale of 0 to 100. 0 is the most fearful; 100 is the most greedy. The midpoint of 50 is seen as neutral. Numbers higher than 50 are indications that the market is greedy and might continue to rise. An index below 50 shows it’s fearful and likely to continue to fall.
How do I use it?
The index is designed for stock markets, because it’s looking to see if stocks are trading below or above their intrinsic value. But that doesn’t mean it isn’t a useful guide for forex investors, because the two markets are inextricably linked. The index isn’t meant to work by itself or to give “signals” like your typical market indicators. Rather, it’s a measure of overall market sentiment and is meant to be useful in combination with other analytical tools (either fundamental or technical analysis).
The index is calculated on a daily, weekly, monthly, and annual basis, so it often is a tool that’s more useful for swing traders than scalpers. But if a scalping strategy is supplemented by following the markets’ trend, then the index can be helpful as well.
Applying fear and greed to forex
When the market is on the fearful side, it tends to boost safe havens. When it’s on the greed side, then risk assets tend to get more support. That translates relatively well into forex, where safe haven and risk flows drive currencies up and down against each other.
So, if the indicator is below 50, then assets such as the dollar and Swiss franc could get support against more risky currencies such as emerging markets and commodities. Gold and silver would be expected to appreciate, but that has to be considered in the context of a stronger dollar. When the index is over 50, on the other hand, commodity backed currencies might get a boost. Typically crude oil rises, which would buoy the Canadian dollar; and demand for raw materials could support the Australian dollar.
