Crypto Fear and Greed Indicator and How to Trade It

Jun 8, 2022 04:10 PM ET
Crypto Fear and Greed Indicator and How to Trade It

Fear and greed are two emotions that drive price action in the cryptocurrency market. Whenever fear grips the market, there is always the risk of prices tanking as investors exit the market and turn to safe-havens. Similarly, whenever greed is the prevailing sentiment, the prospect of price rallying is usually high as buying pressure builds up.

Understanding the fear and greed indicator

The fear and greed index is a technical indicator that provides valuable insights into the prevailing market sentiment, fear, or greed. The indicator ranks sentiments from 0 to 100. Readings of between 0 and 50 signal fear in the market. The lower the value, the higher the fear. On the other hand, readings of between 50 and 100 imply growing greed, with a 100 reading suggesting rampant greed.

Whenever the indicator points towards the fear side, it could mean buying opportunity is nearing. Too much selling often results in oversold conditions that provide an opportunity for bargain hunters to buy at extremely low prices.

Image showing fear and greed indicator

Nevertheless, there is always the risk of price continuing to edge lower even on the indicator showing extreme fear in the market. Just because the indicator shows, fear does not mean that prices will bounce back as oversold conditions kick in.

Similarly, whenever greed kicks in on the indicator rallying above the 50 handle, it indicates the prospect of sell opportunities nearing. The indicator rising above the 90 level could imply overbought conditions on the underlying cryptocurrency being bought too much.

Nonetheless, just because the fear and greed indicator reading is above 90 does not mean one blindly enters a sell position assuming overbought conditions in play. There is always a chance of price continuing to edge higher without reversing course, even on overbought conditions kicking in due to greed.

Data source

Various metrics go into the generation of the fear and greed index readings. They include the following ones below.

Volatility

Cryptocurrency volatility over the past 30 to 90 days accounts for the biggest weight of the index readings. Consequently, the tool uses the market to analyze the rate of price change. The higher the volatility, the more fear in the market and the likelihood of price tanking.

Market volume

Market volume denotes the average trading momentum over 30 to 90 days. A consistent increase in volume signifies that more buyers increasingly buy the cryptocurrency. Conversely, it amounts to increasing greed, signaling that the price is likely to continue increasing.

Social media

There is no doubt that cryptocurrencies are the most speculative instruments in the capital markets. Conversely, the tool tries to analyze traders' sentiments on social media. The more the number of hashtags or interactions on Twitter means a buildup in greed. If social networks are exceptionally quiet, then the fearful index tends to rise.

Image showing markets sentiments at different stages

Bitcoin dominance

Bitcoin is the flagship cryptocurrency that tends to attract the most investment dollars. Conversely, whenever Bitcoin's dominance rises, it triggers fear in the broader market as investors shun the other riskier cryptocurrencies. Likewise, whenever Bitcoin dominance declines, it means individuals are becoming greedy and investing in riskier alt-coins

Surveys

While currently paused, survey results account for 15% of the index readings. In this case, people are usually asked how they feel about the market, consequently giving an idea of whether they are greedy or fearful.

Google trends

The fear and greed indicator also relies on search results on Google to try and predict market sentiments.

How the fear and greed indicator works

The indicators reading are divided into four quadrants. Readings between 0 and 24 imply extreme fear in the market. The extreme fear is often expected to cause significant price declines to levels not expected, affirming a strong sell-off.

The strong sell-off into lower lows also presents a buying opportunity. While prices can continue tanking, the oversold conditions are often a deterrent for short sellers to enter the market and continue pushing prices lower. Very few sellers would be willing to sell at extremely low levels.

Consequently, reading between 0 and 24 acts as a buying opportunity for traders who want to buy at extremely low levels with expectations of generating significant profits as prices bounce back.

On the other hand, a score between 25 and 49 implies that the market is fearful, outweighing any greed. The prospect of a cryptocurrency price tanking is high as short-sellers use the opportunity to enter short positions to profit from price tanking.

Chart showing Price action on fear and greed

When the indicator readings are between 50 and 74, greed is building up, and buyers are increasingly flocking to the market. Given that the buying pressure is just starting, it implies the prospect of price rallying as market momentum shifts from fear to greed. Conversely, this would be the ideal time to trigger long positions.

Finally, whenever the fear and greed indicator readings are between 75 and 100, it means the market is overheating. The higher the reading, the more the greed in the market. As the readings move above the 90 level, this could be a warning sign of a potential price reversal, given that overbought conditions have kicked in.

Price reversals tend to happen whenever the fear and greed reading is above 90, given that buyers tend to exit the market to try and lock in profits on price moving up significantly. Short sellers, on the other hand, use this opportunity to trigger short positions and try to profit from price tanking from higher highs.

Bottom line

The fear and greed index is useful for active traders looking to understand the prevailing market sentiment to predict price action activity. Whenever there is too much fear in the market, as depicted by the tool, it might be the best time to buy the cryptocurrency in line with Warren Buffet's advice. Similarly, caution would be of the utmost importance whenever there is too much greed.

While fear and greed are important tools for gauging the prevailing market sentiments, they should never be used in isolation in price prediction. Therefore, it can be used with the Relative strength Indicator to see if the cryptocurrency is overbought or oversold.


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