Explained: What is Cryptocurrency Fear and Greed Index?

The cryptocurrency Fear and Greed Index touched the lowest level since July 2021 this week to the 'extreme fear' level as the Bitcoin price plunged to $42,000 – the lowest level since late September as a hawkish Federal Reserve sapped investors' appetite for risky assets such as Bitcoin. The number two cryptocurrency, Ethereum-based crypto, Ether also declined 4 percent to $3,200-level.

Like in other markets, there are tools that can help in getting a broad sense of the direction of crypto prices. One such tool that is popular among crypto investors is the Fear and Greed Index.

This index is similar to the stock market fear and greed index, which Investopedia suggests was created by CNNMoney to measure the two primary emotions that influence investors' market decisions.

The crypto index, which is currently only for Bitcoin, captures bearish and bullish trends by gauging investor sentiment for the coin. As the name suggests, the market trend is identified based on two emotions – fear and greed.

Alternative.me, a website that provides statistics and lists various software and their alternatives, designed the fear and greed index to determine the performance of crypto assets. While the index is currently applicable only to Bitcoin, other cryptos are expected to be added soon.

Alternative.me explains: "The crypto market behaviour is very emotional. People tend to get greedy when the market is rising which results in FOMO (Fear of missing out). Also, people often sell their coins in the irrational reaction of seeing red numbers. With our Fear and Greed Index, we try to save you from your own emotional overreactions."

The fear and greed index is on a scale of 0-100, where 0 represents extreme fear, and 100 represents extreme greed. A score of 50 represents neutral, where the investors are neither greedy nor fearful.

In a blog, Alternative.me laid out the two assumptions around investor sentiment. If investors are becoming too fearful, then it could be a good buying opportunity and if they are too greedy, the market may be due for a correction.

The sentiment is analysed based on data from five sources; all of them are valued the same as the day before to represent meaningful progress.

Volatility - the current volatility of the coin is measured and compared with the corresponding average values of the last 30 days and 90 days. High volatility indicates more fear.

Market momentum - current volume and market momentum for the coin are tracked again compared with an average of the last 30 and 90 days. High buying volumes in a positive market on daily basis indicate greed.

Social media - Twitter posts are monitored to keep a check on how fast and how many interactions they receive in a time frame. A higher interaction rate than normal indicates greed. A Reddit Sentiment Analysis may also be added soon.

Dominance - this refers to the market cap share compared to the entire crypto market. When bitcoin's market cap share expands, it indicates investors may be dumping other altcoins due to fear and vice versa.

Trends – Google trends data for various bitcoin-related search queries is bunched up and search volume changes are monitored to formulate a measurable metric.

Weekly crypto polls were also conducted in conjunction with strawpoll.com (owned by Alternative.me) asking investors their view/outlook on the market. However, such surveys are currently on hold.

At the time of writing this article, the crypto fear and greed index reflected fear, with a score of 33. Typically, a score below 25 would signify extreme fear and might be a good time to explore buying opportunities. A score above 75 might mean extreme greed and an ideal time to start booking profits.

However, investors must keep in mind that a single tool such as this index may not present a complete picture of the trend in crypto prices, and relying on just one tool to make any investment decisions may prove to be risky. It is always advisable to research well to make informed decisions.