Fear & Greed Index
Binary options traders are used to thinking that emotions are the worst enemy of every investor. By all means, it’s true but with one exception. Keep reading to learn how to use emotions to your advantage.
The investing barometer
Traditionally binary options trading is considered as a simplified form of investing. For some points it's true but it's hardly as easy as it might seem from the first sight.
Although, there are several ways to measure Fear and Greed on the stock market, the classic one is certainly VIX or CBOE Volatility Index released by Chicago Board Options Exchange. VIX’s one and only purpose is to analyse the sentiment ratio of Wall Street’s fear and greed gauge.
Another way to measure it is FGI or Fear and Greed Index, which was developed by CNN Money to check the primary emotions that drive investors. No matter what you do for a living, you are accustomed to it too and probably on the everyday basis. For good or ill, Fear and Greed are the real rulers of the financial world.
So, how exactly does CNN measure it? Fear and Greed Index is based on 7 different factors with the total score of investor sentiment on a scale from 0 to 100 (from fear to greed accordingly). These factors include:
- Market Momentum - the S&P 500 and its 125-day moving average.
- Safe Haven Demand - based on the difference in returns for stocks versus Treasuries.
- Stock Price Strength - the number of stocks hitting 52-week highs and those hitting 52-week lows on the NYSE (New York Stock Exchange).
- Stock Price Breadth - trading volumes in rising stocks against declining stocks.
- Put and Call Options - based on the Put/Call ratio.
- Junk Bond Demand - as measured by the spread between yields on investment grade bonds and junk bonds.
- Market Volatility - as measured by the CBOE Volatility Index (VIX).
The average of these 7 indicators is what make a Fear and Greed Index.
How does it work?
Financial markets are driven by 2 powerful emotions: fear and greed. Both emotions define human nature and, actually, have a lot in common with love. For instance, greed has the same power to send a chemical rush through our brains that forces us to put aside our common sense and self-control.
One of the most famous examples, which perfectly demonstrate the power of greed, is the Dot-com bubble. It happened in the end of 1990s when internet startups became a new hype and everyone wanted to invest into companies with a “dot com” domain. As an inevitable result, investors became too blinded with greed to notice that securities are totally overpriced and the bubble is already created.
Nowadays, experienced traders think about the Fear and Greed Index as sort of a signal for potential turning points on the market. So, how exactly does it work? If investors are greedy stock prices should rise. On the contrary, if they are fearful prices should fall. In other words, investors buy when the index is above 50 and sell when it’s below that level.
Although it’s hardly possible to rely on this indicator only (or any other for that matter), the Fear and Greed Index can be a useful addition to your stocks trading strategy.