A better understanding of the fear and greed index crypto follows from the review of several important studies. According to recent research conducted by Bank of Canada, most crypto retail investors lack adequate financial literacy despite their medium/high income. Therefore, they are unable to conduct proper fundamental financial analysis and they allocate their funds following their instinct and the market momentum. This behavior generates sharp fluctuations of crypto prices and brings opportunities for those investors who are able to identify when market values are extremely detached from their real values. For this reason, several instruments, including the fear and greed index crypto, were designed to check market participant feelings and try to predict their actions.
Why the Fear and Greed Index Matters
The most prominent tool is the Crypto Fear and Greed index. This index measures fear and greed using a scale that ranges from 0 to 100, where low values represent fear in the market, and high values indicate the opposite.
Historical data has shown that when its value is close to 10 there is a high probability that the crypto market will increase in value as investors have essentially oversold their assets in panic. When the index has reached as high as 80 or more, the market will probably fall as people have over purchased cryptos in response to greed.
It is worth studying how this index is composed.
What the Index is Comprised of
The index focuses on Bitcoin fluctuations, and it integrates the following variables:
- As volatility rises, market fear increases.
- Growing volume at the exchanges suggests an increased interest in the asset.
- Social media hashtags (#) for each cryptocurrency are also considered.
- Surveys are also done to verify people’s opinions as they relate to crypto.
- The dominance of the Bitcoin over the total crypto market is also considered. When Bitcoin dominates, it likely means that investors are feeling fearful as minor cryptocurrencies are the first ones to be sold in case of a crisis.
- Google Trends provides plenty of information on what words are being used and what terms they are associated with. This index extracts data points from Google Trends to better understand the latest concerns, curiosities, and ideas of investors.
Scientific Studies Related to the Crypto Fear and Greed Index
Many studies on stock market have shown that investors tend to overreact to negative information. In fact, consistently, stocks that have a sharp fall in price tend to outperform other stocks by around 25%. It means that investors often panic over negative news and sell their assets even to their own detriment.
Brown & Harlow, in 1988, also investigated whether investors responded to positive news too. Results confirmed the tendency to panic sell on bad news, but response to positive news was less clear. Therefore, people do not necessarily rush to buy assets on positive news.
These findings were confirmed by several researchers from various countries all over the world, indicating that this is a human behavioral trait that is not related to any specific culture. The crypto fear and greed index has been developed based on these findings.
Volatile markets, such as crypto, are more sensitive to this phenomenon as discovered by Mr. Ma in 2005. Ma noticed that the Nasdaq had a much stronger over-reactive effect than the NYSE.
Next step for crypto investors
Science has demonstrated that risky markets are very sensitive to negative news, and it could be a great investment opportunity for participants that are adaptive enough to measure sentiment.
The Crypto Fear and Greed Index could be a great instrument to monitor those conditions when the market acts irrationally.