A detailed explanation of the Fear and Greed Index - What guiding role does market sentiment play?

Author: Crypto_Painter Source: X, @CryptoPainter_X

With the recent BTC briefly falling below the 60,000 US dollar mark, market sentiment has taken a 180-degree turn overnight, from 75% greed a week ago to 30% fear;

Is the market really that fearful?

Since many people are talking about this index, let's analyze it thoroughly today and see what guiding role the market sentiment index plays in trading?  

First, we need to understand how the F&G Index is calculated?

It is calculated through 5 main weights:

1. Volatility: The current volatility of BTC price relative to the past 30 and 90 days. Abnormal increases in volatility can sometimes be a sign of excessive fear in the market.

2. Momentum and Volume: Momentum and volume relative to the past 30 and 90 days. Abnormally high buying volume relative to the past 30 and 90 days can indicate that the market has become too greedy, and vice versa.

3. Social Media: Through sentiment analysis on social media, see the type and amount of sentiment at a specific time relative to historical norms.

4. BTC dominance rate: Bitcoin's advantage over other cryptocurrencies.

5. Google Trends: Identify periods of strong growth or decline in Google searches through Google Trends for a range of related Bitcoin search terms.  

After understanding the above information, we can further understand the reasons for the changes in the fear and greed index;  

Obviously, the main reason for the current BTC 30 fear index is not 1 and 2, because its volatility and trading volume have not increased significantly at the weekly level, so the factors that are more likely to affect the index should come from 3~5;  

Among them, social media data cannot be obtained accurately, and I can only rely on my personal feelings. Users on Twitter did not feel extremely panicked, but many of them were bottom-fishing;  

Google Trends maintained a slight increase and no obvious changes; Then the main change can only appear in the dominance rate of BTC. When the market fell sharply the day before yesterday, many people found that the altcoins did not follow the decline at all, which led to a sharp decline in the dominance rate of BTC, which dropped by nearly 4% from the local high. It should be noted that in terms of the market value of cryptocurrencies, a 4% decline is indeed not a small number! This may be the main reason for the rapid decline of the Fear and Greed Index; Therefore, we can draw such a conclusion that BTC is not in fear at the technical level at present, but the calculation result of the index has changed simply because of the strength of altcoins. Next comes the interesting part. Has this happened in history?

I divided the BTC Fear and Greed Index into numerical areas and manually marked them on the BTC weekly chart, and I got the following chart:

The green mark indicates that the BTC Fear and Greed Index has historically been above 70, which means it is generally in the greedy or extremely greedy stage;

and the orange mark indicates that the index is in the fear stage between 10 and 30;

The last is the red mark, which represents the stage of extreme fear of BTC in history; We regard the unmarked positions as the neutral stage of normal fluctuations in market sentiment; From the green arrow in the figure below, we can see: In the last two rounds of BTC halving cycles, if the bull market comes, the fear and greed index will show a series of long-term green greed marks; After the green greed mark lasts for a long time, an orange fear mark will suddenly appear, just like this time. If the orange fear mark fails to last for more than 3 weeks and BTC re-enters the greed state, it often indicates the arrival of a bull market!

If this orange fear mark starts to appear continuously for more than 3 weeks, then there is a high probability that BTC will usher in a huge correction or directly end the bull market;

Therefore, we can analyze the significance of the fear and greed index from a dialectical perspective, that is, the market sentiment of fear often represents an excellent bottom-fishing and position-adding point when the bull market is in progress, and before the bull market is about to end, it represents an excellent opportunity to escape the top;

However, from my personal perspective, the current market situation seems to be somewhat biased towards the latter, mainly for two reasons:

1. The price did not break a new high and did not rise continuously, but it was obvious that the bull trend 3 months ago turned into a wide range of fluctuations;

2. The oscillation lasts too long, and at the same time, the market sentiment is often greedy;

Of course, I am not suggesting that everyone should escape the top. It has been clearly stated above that the most suitable basis for judgment is the emergence of fear for 3 consecutive weeks, not just a few days at the moment. After all, in September 2021, there was a continuous 2 weeks of fear, but the price eventually rebounded and broke the new high!

After talking about the greed part, let's take a look at extreme fear (<10)? As shown by the red arrow in the figure below:

Since 2019, when the market sentiment reaches extreme fear for the first time in a bull market, it often represents the end of the bull market, and then it will enter a bear market for a period of time. When the bear market lasts for a period of time, when the market sentiment of extreme fear appears for the second or third time, BTC is often very close to the bottom!  

That is to say, when BTC price shows extreme fear in the market for the first time at a high level, the next opportunity is to escape the top. If the price does not fall below the original shock range, you can wait for a small rebound before shipping;  

And when extreme fear appears in the market for the second or third time in a bear market, remember the closing price of the most frightening day. Below this price, it is a good opportunity to gradually build a position or invest in fixed investments. Of course, the black swan of 3-12 is an exception, because it only gives 3 days to build a position;  

Finally, the above conclusions are summarized into a chart:

It can be seen that using this sentiment analysis method, although it is not possible to escape the top perfectly, it can almost accurately copy the bottom of the range;

At the same time, the first green greed mark that appears at the end of a bear market often represents the beginning of a new bull market!

Therefore, we should have a diversified attitude towards this fear and greed index. It is not that the market panic is definitely the bottom, and the market greed is definitely the top; when the price is low, the force that drives the price up must come from the greed of traders who want to buy at a low price, and when the price is high, the force that causes the price to fall often comes from the fear of traders who want to cash out at a high price; through this layer of emotional analysis combined with our own technical analysis and trading system, theoretically, it is possible to achieve absolutely no mistakes in the big cycle. To be honest, in my opinion, the two emotions of fear and greed correspond to the inherent supply and demand of the market. As the price of BTC is increasingly affected by macro factors and traditional institutional funds, this emotional fluctuation will inevitably become less extreme.  

Therefore, what we need to face may no longer be the external collective emotional state, but our own internal psychological state.