Last Updated on December 6, 2019
If you’re planning on making money trading stocks, then it’s certainly worth knowing how the fear and greed index works. Essentially, it is a popular method of determining stocks and their worth. It works based on excessive fear, acknowledging that such panic results in stocks trading greatly below their intrinsic values. The greed element then refers to stocks being bid way above the value of what they’re actually worth.
Fear on the stock market results in a stock price decrease as:
- Trading fear sets in
- Selling begins in earnest
- Greater supplies of stocks become available for sale
Greed on the stock market results in a stock price increase as:
- Trading greed sets in
- Buying begins in earnest
- Greater demand for stock is ignited
VIX Fear Gauge
The VIX Fear Gauge, otherwise known as the Volatility Index, is a real-time market index. It is used as a representation and measurement of both market risk alongside the sentiment of investors.
The VIX is utilized by investors as well as portfolio managers and analysts. They will look to the VIX as a means of measuring the market risk before making those all-important investment decisions. This also includes determining the current fear, stress, and volatility of the current marketplace, as well.
There are two parts to observing a VIX Fear Gauge. These include a Low VIX price and a High VIX price:
A High VIX Price = Anything above the level of 20 here indicates fear in investors. This is because Put Options are increasing, and therefore downside insurance is covering up such trades.
A Low VIX Price = Below 20 suggests a good marketplace. This means stock prices are continuing towards a normal upward course.
NYSE Advance/Decline Ratio
The NYSE Ratio, also referred to as ADR, is the New York Stock Exchange breadth indicator ratio. This is the calculation of advancing and declining issues on the current stock market.
NYSE Ratio Rises: When those advances exceed the declines
NYSE Ratio Declines: When those declines exceed the advances
Here, fear and greed are shown through price, while rising stock prices also suggest traders are feeling overwhelmingly self-assured.
S&P 500 Weekly Chart Above Moving Average 9
The S&P 500 is a weekly line chart that can aid those longer-term investment decisions, improving results in the process. It does this by using two price lines and a nine-plot period moving average technique. The thick line indicates a price line, while the thin line is the moving average.
Therefore, when the price on an S&P chart moves above the average, it indicates that investors are usually greedy and price trending is up.
Whereas fear on an S&P chart comes in the form of the price line moving below the average line.
AAII Sentiment Indicator
Also known as the American Association of Independent Advisors, the AAII is an indicator measuring the percentage of individual investors. This is done via those who are bullish, bearish, and neutral when competing on the stock market.
The AAII works by highlighting the necessary indicators for buying and selling.
When AAII Sentiment is extremely high = It’s an indication to sell stocks
When AAII Sentiment is extremely low = It’s an indication to buy stocks
What is Meant by Boom and Bust?
Boom & Bust refers to a period of rapid economic growth or thriving prosperity, which is then followed abruptly by an economic decline.
This is a cycle and economic process that occurs throughout the stock market repeatedly. It can be seen in action as the economy grows, and the job market is good, with the market bringing some high returns to investors.
However, as the economy starts to shrink, the following bust sees people losing such jobs while investors lose their money.
A boom & bust cycle can last for a varying amount of time, and the severity of it alongside its implications can also vary greatly.
Many well-known US boom & bust cycles can be traced back as far as 1929, though perhaps one of the most recent and well documented has to be that of what is now referred to as the Dot-Com Bubble.
A historical period of excessive speculation, primarily within the US, the Dot-com bubble covered the period over six years, from 1994 to 2000. This was fueled by a swift rise in the use and of course, adoption to the world wide net.
With its value peaking at the beginning of 2000, particularly for those internet-based companies, the crash or rather cause of the bubble bursting was considered a dot-com crash. This bust era continued for four years, with many online companies eventually shutting down because of its excessive and long drawn out nature.
How Extreme Greed and Fear Can Create Boom & Bust
Greed and fear play a coherent part in the process of a boom & bust cycle. This is because investors will become nervous as the stock market starts to show signs of decline or crashes. This nervousness leads to them rushing to sell their stock.
However, though selling to recuperate their money and ward off any potential losses here, these investors will also make a concentrated effort to purchase what are considered to be those safer investments. These are investments that will not traditionally lose their value. This includes things such as gold, bonds, and the US dollar. This is, therefore, the greed element in action.
However, for those looking to capitalize on the process of fear and greed on the stock market, it’s a concept worth taking note of to help you guide your investing decisions hereon.
Considered a sound investment tool now by many stock market professionals, those who are successful in this high-intensity market understand that both fear and greed can have great impact on everyday market trading.
For as many successful people as there are who’ve worked in this industry for years now, unfortunately, there are still many people who participate in this fast-paced environment with little to no planning and a sheer lack of the basics.
So, by understanding how people make their investment decisions, you gain more insight and can determine how they’ll make their next move, thus improving on your own trading fortunes.