What is the Fear and Greed Index?

Two primal forces govern financial markets: fear and greed. We observe it daily when important news comes out and stock markets feel the shock, as in the case of tariffs. To help investors measure these emotions objectively, experts have developed the fear and greed index, which is Wall Street’s “mood ring”. In this guide, we will discover how this powerful contrarian indicator works and how to leverage its power in your trading and investing alongside best practices to avoid emotional pitfalls. 

What Exactly is The Fear and Greed Index?

The fear and greed index quantifies market psychology on a scale of 0-100, where 0 is extreme fear and 100 is extreme greed. The index was originally popularized by CNN Business, and it aggregates multiple data sources into a single snapshot of investor sentiment. The fear and greed data are backward-looking and reflect current sentiment, not future predictions. However, knowing what the overall psychological state is in the markets can give investors a certain advantage over unsuspecting investors. 

Core Components of The Fear and Greed Index

The index contains the six main components:

1. Stock Price Momentum

S&P 500 versus the 125-day moving average. 

1. Market Volatility (VIX)

Closely measures the expected turbulence. 

1. Put/Call Options Ratio

Tracks bearish versus bullish bets in options (put versus call).

1. Market Breadth

Calculates a percentage of stocks hitting 52-week highs and lows.

1. Safe-Haven Demand

Measures flow into bonds and gold versus stocks to determine whether investors are opting for safe-haven assets or feeling confident to invest in stocks. 

1. Junk Bond Spreads

Measures risk appetite in credit markets. 

Each component is graded, normalized, and averaged. For example, if the volatility (VIX) index spikes, it pushes the index toward fear. 

How Traders Use The Index as a Filter

The index, like everything else in trading and investing, is not a crystal ball; it is a confirmation tool. It can be used to validate or challenge your strategy. 

Entry and exit signal filtering

When the fear and greed index reading deviates between 0-25, it is a good idea to screen for oversold assets. For example, during the 2020s’ extreme fear, the S&P 500 rallied almost 60% in 12 months. So, this would be a good opportunity to patiently wait for the best opportunity to buy. 

Extreme greed is when the indicator deviates between 75 and 100. This is a good time to capitalize on profitable opportunities and search for exits. In January 2020, a greed peak at 95 preceded a 34% COVID crash. Although this was an extremely rare event, corrections are natural after strong rallies. The index thrives on a paradox: when crowds panic, opportunities emerge; when euphoria peaks, danger looms.

Another good method for the index is to use it directly as a filter. When it is in the fear territory, sell trades have a higher probability to succeed, and the opposite is true when it goes beyond 50. However, when you see the index go into extreme mode, it is time to rethink your strategy and plan for potential corrections, especially if there was a strong rally. 

Position sizing

When fear dominates, experienced traders scale into buys slowly and reduce exposure slowly when greed is present. As we can see, the index is like RSI, and it shows oversold and overbought conditions, but with the psychological bias of the market participants. 

Maximizing The Index’s Power – The Best Practices

It is an axiom in financial trading that there is no one single best indicator. No indicator, no matter its power, could be used as a standalone indicator, and it is always a good idea to combine several of them. Not too many, not too few. Never use the sentiment alone; use it to filter opportunities, not as a trigger to trade. Confirm it with either fundamentals or technical analysis. In trading as well as investing, context is everything, and a bull market can persist for months. To mitigate this risk, monitor trends, not just numbers alone. Three days of rising fear? Watch for the correction in the bull cycle. Another important aspect is to build discipline by consistently analyzing the fear and greed data, separating your decisions from the herd mentality, and basing your trading decisions on objective data rather than feelings.