Stock Market Fear Index Explained to Beginners

The stock market fear index describes a popular saying that describes financial markets dependent on greed and fear - the two most powerful emotions. This is why the full name sounds like the stock market fear and greed indicator. It is a tool that makes it possible for stock traders to define if the asset price is fair enough. Besides, the index makes it possible for investors to gauge the market movement.

The stock market fear index provides enough flexibility, as traders can apply it to different time frames using it on a weekly or monthly basis or even measuring it within a yearly period in case you need to have a deeper market overview. Today, we will discuss the way it works and what benefits it can bring to traders.

What Is the Stock Market Fear Index and How Does It Work?

The idea behind the index supposes a price that is driven down by excessive traders’ fear while the greed will inevitably create the opposite effect and drive the price up. It happens because the majority of investors still make decisions based on their feelings and emotions. Most traders are unable to keep control over the situation.

As a result, we have a market fear index as the variation of so-called equity markets. CNN was the first to introduce this term that can be measured using 7 different factors rated by the scale from 1 to 100. These factors include:

1. Stock price momentum.
2. The strength of the asset price.
3. Stock price breadth.
4. Put and call options.
5. Safe-haven demand.
6. Junk bonds demand.
7. Market volatility.

Each of these factors is of the same importance to measure stock market fear and greed index. It means they all have the same weight when determining the fear rate. If all of these factors are rated above 50, the situation describes greed as the market driving force. If the rate is below 49, we observe the market fear. If the rate is equal to 50, the situation can be described as neutral.

Benefits of Using Stock Market Fear

According to researchers, when a person feels greed, it is usually set aside common sense and loses control over the situation. Of course, traders are hardly aware of the biochemistry of greed or fear. What we do know is that these feelings appear to be probably the most powerful motivators.

Note: historically, the market fear index has been one of the most reliable indicators of significant changes taking place within equity markets.

The idea of the market fear effect is also supported by the concept of behavioral economics that describes the way investors can change their attitude to the market and act to oppose their strategy. The majority of experts agree that the market fear and greed index is a reliable tool in identifying market sentiments and taking specific decisions. Proven pros recommend having so-called fear tabs to keep the track record to leverage purchasing opportunities.

As for the benefits, they include:

• Market fear is a time-tested and reliable indicator that is based on the concept of behavioral economics.
• The index can be used to ensure proper investment decisions when trading stocks and other instruments.
• The tool can be applied to different time frames using either a weekly or yearly basis.
• Quite simple to read, which makes it good for beginners.

Downsides of Stock Market Fear Index

You will never find this tool in a technical toolkit. It means that you should not consider it as a market/investment research instrument. The index works as a motivator for traders to act depending on the market volatility but it does not ensure any fixed outcome.

The Bottom Line

Some skeptics consider the market fear rather than an indicator that can be used as the barometer within the market timing. They say that this approach can generate lower returns if compared to buy-and-hold strategies. On the other hand, we cannot ignore the efficiency of the tool for investment decision-making.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.