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The best investors use a variety of tools to predict asset prices. For example, CNNMoney invented the Fear and Greed Index. This index measures the performance of stocks on a daily, weekly, monthly, and yearly basis. Based on the two opposing emotions of fear and greed, the index aims to provide insight into the emotional climate of the market. Therefore, this tool can help investors predict the direction of future prices. For example, a booming stock price can be an indicator of greed as investors keep buying the stock in anticipation that it will continue to rise in price. In contrast, fear is recognized by a falling stock price when investors keep dumping a stock after a massive sell-off. Therefore, excessive greed can inflate the stock price and make it overvalued whereas fear can cause the stock to free-fall and make it undervalued. According to value investors, a good time to buy a stock is when the market is fearful and it is undervalued because prices will eventually go back up. However a good time to sell a stock is when the market is greedy and is overvalued because prices are due for a correction.
The behavior of prices in the cryptocurrency market is similar to the stock market and highly emotional as well. When the market is bullish, many investors enter the market due to the “fear of missing out (FOMO).” Whereas when the market is bearish, the same investors dump all of their cryptocurrency holdings in fear that prices will continue to drop. With the Bitcoin Fear and Greed Index, investors now have a tool to assess market sentiment and mitigate bad investing decisions due to high emotions. Now, let's dive-in to understand more about the Crypto Fear & Greed Index and how it works.
What is the Crypto Fear & Greed Index?
Alternative.me depicts the Crypto Fear & Greed Index. The Fear & Greed Index on a 1-year basis looks like:
Source: Alternative.me
0 represents the lowest level of greed and the highest level of fear in the market. In contrast, 100 represents the highest level of greed and the lowest level of fear. These are the two extremes of the Index. In the above graph, when the index drops below 20, it depicts extreme fear. However when the index rises above 60, it represents excessive greed.
According to the graph, on August 11th 2020, the Fear and Greed Index for Bitcoin reached a value of 84 (from 0-100), indicating Extreme Greed. During this time, the BTC price was $11,556.20, which indicated a good selling opportunity. On the other hand, from March 9th to March 24th, 2020, the index flashed Extreme Fear, as the value of the index was between 8-20. During this time, the BTC price dropped to $5,358.
How does it work?
Each of the indicators mentioned below is measured on a scale from 0-100. Based on that value, an equal-weighted average of each item is calculated, which generates a value for the Fear and Greed Index. Specifically, Alternative.me created their Bitcoin Fear and Greed index based on six data sources.
Volatility (25%)
An unusual rise in volatility indicates fear in the market. The current volatility and maximum drawdowns of Bitcoin are compared with the corresponding average values of the last 30 days and 90 days.
Market Momentum/Volume (25%)
A ratio of the market momentum and current volume is compared with the last 30 and 90-day average values. When buying volumes are high, it usually is indicative of a greedy market.
Social Media (15%)
A Twitter sentiment analysis that accumulates posts on various hashtags for each coin. It analyzes the speed, and the interactions received during certain periods. If there is an unusually high level of interactions around a specific coin, then it indicates a greedy market.
Surveys (15%)
Alternative.me conducts polls on platforms like strawpoll.com to analyze how people perceive the market. They get an average of 2000-3000 votes per poll. However they have currently removed this source of information from the index.
Dominance (10%)
The dominance of a coin corresponds to the market cap share of the whole cryptocurrency market. In the case of Bitcoin, a rise in Bitcoin dominance may signal fear in the market as investors flock to Bitcoin for a safer investment. However, a fall in Bitcoin dominance may signal investors have an appetite for riskier assets such as other cryptocurrencies.
Trends (10%)
Alternative.me analyzes the Google Trends data for various Bitcoin search queries. A sudden rise in specific keywords can provide insight into the current crypto market sentiment. For example, if there is a rise in the search volume of "How to buy bitcoin," it shows the market is getting optimistic.
Limitations
Although the index may help an investor better understand market sentiment, that does not necessarily translate into being able to time the market and choose the best time to buy and sell. For example, extreme fear may indicate a low price however bearish news could make the price dip even further. In contrast, extreme greed may result in a high price but bullish news could push the price even higher. In other words, the index can help investors take the market’s temperature but does not offer investment advice. That being said, the index can still be useful in combination with other tools to help an investor better understand market sentiment.
