If you’re a crypto investor, chances are you might have stumbled across the Crypto Fear and Greed Index on social media or in the news. The Crypto Fear and Greed Index is a metric designed to gauge the market sentiment of cryptocurrency at any given time.

It is important to understand the structure of the index, what it captures and what it tells you about the market so you can decide whether it’s an indicator you should pay attention to for your investment decisions.

What is the Crypto Fear and Greed Index?

The index generates a single number, between 1 and 100, with 1 indicating that the crypto market is in a state of extreme fear (meaning people are selling,) while on the other end of the spectrum, 100 indicates that the market is undergoing an extreme level of greed (meaning people are buying).

A general rule of thumb is that when the index value is at 1, this generally correlates to a buying opportunity. This is because the number 1 indicates “extreme fear” in the market, meaning people are afraid of buying at this time, and the price may be deflated as people stay away or sell over fears the crypto is going to lose value. As billionaire American investment guru Warren Buffett once said, “buy when there’s blood in the streets.”

Read more: 4 Tips to Maximize Your Crypto Investment

On the other hand, if the index is showing 100 it would be seen as “extreme greed” and would generally be interpreted as a sell signal. Think of this as a rush of people trying to get into a hot market at any price, as they want to get into a meteoric rise as investors saw with meme stocks in 2021. When prices rise quickly, there’s a chance prices will sharply reverse and fall just as fast.

To make this simple: When the Fear and Greed Index value is low, this may signal that the crypto price will increase, and when the index value is high, this could indicate the crypto price will soon move lower.

How the Fear and Greed Index is calculated
So how do they arrive at the final number? There are multiple factors that influence the ultimate output.

Volatility: The index compares volatility and max drawdowns (a drawdown is a decline in value) against the 30-day and 90-day average volatility and drawdown numbers. Higher volatility is considered fearful and increases the final output. Volatility represents 25% of the index value.
Momentum/volume: The index measures the current momentum and volume of the bitcoin market. Again, against the 30-day and 90-day averages. High volume and momentum are seen as negative metrics and increase the final index output. Momentum/volume represents 25% of the index value.
Social Media: The index tracts mentions and hashtags for bitcoin, and compares them to historical averages. Higher mentions and hashtags are interpreted as increased market involvement and lead to an increase in the final index output. Social media represents 15% of the index value.
Surveys: The index conducts large, market-wide surveys on a weekly basis. Usually, there are 2,000-3,000 participants in each survey. More enthusiastic survey results drive the index higher, pointing to market greed prevailing. Surveys represent 15% of the index value.
Dominance: The index measures bitcoin dominance in the overall market. The higher the bitcoin dominance, the more fearful the market – as interpreted by the index. As alternative coins gain market share, the market is acting courageously and not fearfully. The lower the bitcoin dominance, the greedier the market is becoming. Dominance represents 10% of the index value.
Trends: The index includes Google trend numbers in the final value. The higher the search interest of cryptocurrency becomes; the higher amount of greed is seen in the market. Trends represent 10% of the index value.
Is the Fear and Greed Index reliable?
The question becomes: Does the fear and greed index provide insight into the future price of cryptocurrency? LookIntoBitcoin.com has charted the Crypto Fear and Greed Index against the bitcoin price, going back to 2018.

The price and index value seem to be quite correlated – albeit over a relatively short period of time. A higher bitcoin price seems to have led to a higher Fear and Greed index value.

There are a few things to consider when using the Fear and Greed Index as a trading indicator. Ask yourself a few important questions:

Am I a trader or a long-term investor? If you are a trader and constantly moving in and out of crypto positions, you might gain insight from following the index value. If you are a long-term investor, actively trading might result in you missing major rallies and ultimately decreasing your total return.
Have I thought about my tax strategy regarding cryptocurrency? If you’re actively trading, either day trading or swing trading crypto based on technical indicators such as the Fear and Greed Index, you’re more prone to short-term capital gains tax (the same as income tax) on your gains. It is crucially important to factor this into your trading decisions.
Am I a fundamental or technical trader? The Fear and Greed Index is a technical indicator. It does not consider any fundamental factors of cryptocurrency in its final output. If you are investing in cryptocurrency based on a macroeconomic outlook, for example, it’s easy to argue that the Fear and Greed Index is entirely irrelevant to your investment thesis.

Source https://www.coindesk.com/learn/the-crypto-fear-and-greed-index-explained/

By block head

Block Head is a blockchain journalist.