The SAVI Indicator The JSE introduces a new “Fear Factor” Investor greed and fear play a significant and often irrational role in any financial market. These market sentiments can be seen in the volatility of the market – high volatility with large market moves suggest a fearful market while low volatility with little market movement indicates a lack of fear. How can investors measure this market sentiment and use this in their investment decisions? A volatility index or “fear gauge” is a reference number that can be used to indicate market risk at a glance. The first volatility index known as the VIX was developed by the Chicago Board Options Exchange in 1993 to measure the volatility of the S&P500. In 2007, the JSE launched the South African Volatility Index or SAVI to measure equity risk in South Africa; this was the first of its kind in an emerging economy. The SAVI is similar to the VIX, with the difference being that the US index measures implied volatility over one month, while the SAVI looks forward three months. The Ultimate "Fear Gauge" For Beating the Crowds to Big Profits It may be as cliché as it gets, but it's true. Investors are motivated by two things and two things only: Fear and Greed. It's just that simple. So more often than not, they turn quite bullish when they think a stock is headed higher and quite bearish when they fear that all is lost. The trouble with this strategy though, is that for most retail investors, it is exactly at these extremes in sentiment that they often lose their shirts. Because while conventional financial theory does suggest the idea that markets behave rationally, not accounting for the emotional aspect of the trade often leads to all of the wrong entry and exit points. And believe the following: It's hard to turn a buck on the Street when you're constantly getting either one or both of them wrong. That's why successful technical analysts often rely on the SAVI indicator to assess whether or not the current market sentiment is either excessively bullish or bearish in order to plot their next move. Make Better Trades Using the Fear Gauge You see, the SAVI is one of the so-called contrarian indicators. That is, it tells you whether or not the markets have reached an extreme position one way or the other. If so, that tends to be a sure sign that the markets are about to stage reversal. The idea here is that if the wide majority believes that one bet is such a sure thing, they pile on. But by the time that happens, the market is usually ready to turn the other way. Of course, as usual "the crowd" hardly ever gets its right. (So much for the rational market theory) So the smart money simply uses the SAVI indicator as a sign to bet against them all. If "the crowd" is feeling very bullish, in other words, it is definitely time to think about getting bearish. It's counter-intuitive for sure, but it works nearly all of the time-especially in volatile markets. And that's why the SAVI indicator is a trader's best friend these days. After all, if there is one way to describe today's markets it would have to volatile. So What Is the SAVI Indicator? The JSE launched the South African Volatility Index or SAVI to measure equity risk in South Africa. But because it is basically a derivative of a derivative, it acts more like a market thermometer more than anything else. And like a thermometer, there are specific numbers that tell the market's story. A level below 22 is generally considered to be bearish, indicating that investors have become overly complacent. Meanwhile, with a reading of greater than 28, a high level of investor fear is implied, which is bullish from a contrarian point of view. The smart thing to do then is to wait for peaks in the SAVI above 28 and let the SAVI start to decline, before placing your buy. As the volatility declines, stocks in general will rise and you can make big profits. You see it time and time again. In fact, the old saying with the SAVI is, "When the SAVI is high, it's time to buy. That's because when volatility is high and rising, that means the crowd is scared. And when the crowd is scared, they sell, and stock prices fall dramatically, leaving bargains for money making traders. The SAVI Indicator in Action Here's an example of how it works in the real world. It comes in the form of one reversal and one continuation in the JSE All Share, each one of them successfully predicted by the SAVI using its 200 day exponential moving average (EMA) as the basis of each move. Take a look at the charts: As you can see, every time the SAVI either breached or touched its 200 EMA the ALSI reversed and began to increase. And not surprisingly, each of those moves occurred when the index told us that fear levels were high. Conversely, of course, both charts show that rallies ensued not long after the index spiked above 28, which represented times of great fear. And for smart traders, each occasion was the equivalent of taking candy from babies, simply by betting against the "wisdom" of the crowd. How to Play Market Volatility But it's not just a reading of "under 22" or "over 28" that works with the SAVI. That's a bit too simple. On top of those levels, smart traders also add the price movement within the Bollinger Bands into the mix. of late, that has been one of the key tells in predicting the market action. So what are Bollinger Bands you ask?... Bollinger Bands are a popular technical indicator for traders to determine overbought and oversold conditions. In a range-bound market, for example, it works even better as prices travel between two "rubber bands," or like balls bouncing off the walls of a racquetball game. For instance, on the chart you can actually see these "rubber bands" in action... Check it out: As the ALSI trades, volatility rises or falls as it bounces off of the upper or lower bands. It's these extremes that have marked the major market turning points from a contrarian perspective. One way to play these market moves is by trading between these two exchange traded funds (ETFs): x Go Long the JSE Top40 Index Call warrant as the SAVI falls to the bottom of the Bollinger Bands. This warrant rises as broader markets top and begins to fall. x Go Long the JSE Top40 Index Put warrant as the SAVI rises to the top of the Bollinger Bands. This warrant rises as broader markets bottom and begins to head higher. These and other winning options strategies can help you put fear and greed in their place, earning you big profits as you trade the extremes in market sentiment. After all, when Ben Bernanke admits the economic outlook is "unusually uncertain", you can bet that market volatility is not that far behind. That's why the SAVI Indicator is so popular these days. So don't trade without it. After all, if there is one other thing that we know for sure about fear and greed it is that they never ever take a break. .