Fear And Greed Trading Strategy: Can It Be Quantified?
Investing is as much about psychology as it is about numbers. Fear and greed, two fundamental human emotions, significantly influence market dynamics. Fear can lead to panic selling during market downturns, causing sharp declines, while greed can drive speculative bubbles, inflating asset prices beyond their intrinsic value. These are called trading biases.
Recognizing these emotions is crucial, but can they be measured and turned into a strategic tool for investors? This survey note explores the concept of quantifying fear and greed, focusing on CNN’s Fear and Greed Index, and assesses its potential as part of an investment strategy.
CNN publishes a daily Fear and Greed Index. Can we use it to create a fear and greed trading strategy?
Understanding Fear and Greed in Investing
Fear and greed are natural responses that can distort rational decision-making. During market downturns, fear often prompts investors to sell assets at a loss to avoid further declines, exacerbating market drops.
Conversely, during bullish phases, greed can lead to overbuying, pushing prices to unsustainable levels.
These emotional swings create market inefficiencies, which contrarian investors may seek to exploit. However, managing these emotions requires tools to measure their impact, leading to the development of sentiment indicators like the Fear and Greed Index.
The Fear and Greed Index: A Sentiment Barometer
The Fear and Greed Index, developed by CNN Business, is a widely recognized tool designed to quantify investor sentiment.
It provides a numerical score from 0 to 100, where 0 represents extreme fear and 100 indicates extreme greed. This index aims to reflect the emotional state of the market, offering insights into whether stocks are fairly priced based on prevailing sentiment.
For instance, a low score might suggest undervaluation due to fear, while a high score could indicate overvaluation driven by greed.
Methodology: How the Index is Calculated
The CNN Fear and Greed Index is calculated using seven equally weighted market indicators, each capturing a different facet of investor behavior and market conditions. These indicators are:
| Indicator | Description |
|---|---|
| Stock Price Momentum | Compares the S&P 500 to its 125-day moving average; positive momentum signals greed, slowing momentum indicates fear. |
| Stock Price Strength | Measures net new 52-week highs and lows on the NYSE; more highs signal greed. |
| Stock Price Breadth | Uses the McClellan Volume Summation Index; decreasing volume signals fear. |
| Put and Call Options | 5-day average put/call ratio; a ratio above 1 is bearish, signaling fear. |
| Market Volatility | Compares VIX to its 50-day moving average; increasing volatility signals fear. |
| Safe Haven Demand | Shows the difference in 20-day stock and bond returns; bonds outperforming signals fear. |
| Junk Bond Demand | Measures yield spread between junk bonds and investment-grade bonds; smaller spread signals greed. |
Each indicator is standardized and equally weighted to produce the overall index score, updated as new data becomes available. This methodology ensures a comprehensive view of market sentiment, reflecting both broad trends and specific market behaviors.
Strategic Application: Can It Be Used as a Trading Strategy?
The Fear and Greed Index is often employed as a contrarian indicator, based on the principle of buying low and selling high in emotional terms.
For example, when the index shows extreme fear (low values), it may indicate undervalued stocks, presenting buying opportunities.
Conversely, when it shows extreme greed (high values), it might suggest overvalued assets, signaling potential selling points.
This approach aligns with Warren Buffett’s advice to “be fearful when others are greedy and greedy only when others are fearful.”
However, using the index as a standalone strategy has limitations. Market sentiment can remain irrational for extended periods, and timing the market based solely on sentiment indicators can be risky.
For instance, during prolonged bear markets, fear may persist, and buying at low index values could still result in losses if the downturn continues.
Empirical Evidence: Backtesting the Index
We don’t have the data of CNN’s Fear and Greed Index, so base our research on other people’s research.
For example, CNN Fear and Greed Index as trend signal in global financial markets shows that the index can be used successfully to create a fear and greed trading strategy.
The authors tested the following hypothesis:
For this we have developed an algorithmic trading system that opens a position on Monday of each week from the last value published for the CNN Fear & Greed Index. If the published value is less than or equal to 25, we are in the “extreme fear” zone and the system will open a long position in the futures market. If, on the other hand, the signal is “extreme greed” (more than 75 points), a short position will be opened. The system will remain out of the market if the index is not at one of these two extremes.
The results are summarized in this table (using futures contracts from over a period of two years (only):
The profit factor indicates that the results are positive, but mixed. We like to see numbers above 2. The French CAC index was the performing contract.
Broader Context: Application Beyond Stocks
While this note focuses on the stock market, it’s worth noting that the concept of quantifying fear and greed extends to other markets.
For instance, CoinMarketCap offers a Crypto Fear and Greed Index, applying similar principles to cryptocurrencies. This index, ranging from 0 to 100, helps investors gauge sentiment in the volatile crypto market, suggesting the broader applicability of sentiment indicators.
However, for the purposes of this discussion, we focus on the stock market version given its established use and relevance.