The Basics

The Fear or Greed sentiment index visually represents how bullish or bearish non-institutional (”retail”) traders are on a given asset. Many scientific studies highlight that humans have many cognitive biases that make us poor predictors of future events. The highest retail trade volume levels typically occur near the end of directional moves when examining market tops and bottoms. Knowing when retail sentiment is at an extreme and trade volume is elevated can be a key to identifying when the crowd may be wrong and prices are about to move in the opposite direction.

Visual Elements

The Fear or Greed Index images will have these elements:

1. FOG Line (Yellow): Represents the Fear or Greed index.
2. Current Value Dot (Blue): Represents the current day value of the index.
3. Mid Line (Gray): Represents the divider of majority bullish or bearish sentiment.
4. Greed Area (Red): This represents the region of extreme bullish sentiment and potential for a bearish reversal.
5. Fear Area (Green): This represents the region of extreme bearish sentiment and the potential for a bullish reversal.

Utilizing Sentiment

1. Contrarian Base Case

Below is the weekly chart of the S&P 500. Above some candles is a magenta down arrow. This shows the times the FoG Index moved into the red greed area. Below some candles is a green up arrow. This shows the times the FoG Index moved into the green fear area. Sentiment can be a basic timing indication, as evidenced by price reversals of varying magnitudes after reaching extremes.

2. Irrationality

While using sentiment as an indicator has its merits in the base case, it is also evident that there are occasions where the crowd had the right idea for a while before the price corrected enough to shift sentiment. The white arrows below indicate the "correctly" timed sentiment indications. It is important to note that the market can remain extreme and behave irrationally for extended and unknown periods, especially when considering bullish price action.

3. Sentiment as the Setup

To weed out some irrationality, sentiment extremes should be paired with objective technical factors. The extreme sentiment is the setup for a trade; next, a signal should be identified as an entry. Those can include but are not limited to:

• A close below support on the same timeframe after a greedy extreme.
• A close above resistance on the same timeframe after a fearful extreme.
• A period of consolidation, then a break of that range in the opposite direction of sentiment after an extreme.
• A momentum-based trading signal in the opposite direction of sentiment after an extreme.
• A count-trend trade signal using tools such as pitchforks, Bollinger bands, or Keltner channels after an extreme
• A mean reversion (divergence) trade signal, such as my Correction Strength Meter indicator after an extreme.

It’s just the start…