Momentum is something most of us understand intuitively. Momentum is most relevant to traders who always need to trade on the side of the momentum. For example, if the basic momentum of RIL is on the positive side then your basic approach to trading should be on the long side. One of the basic rules of trading is that momentum represents trend of the stock and trend is always your friend in trading. Hence a smart trader will always try to be as close and as aligned to the momentum of the market as possible.
Direction is a slightly longer term perspective. A very generic statement could be that the direction of the Indian markets is higher. That does not mean that one can initiate a long trade in the market right away. It only means that if you are long on the right stocks then you are more likely to make money. It does not make sense to sit on cash when the direction of the market is up just as it does not make sense to stay invested in markets when the direction of the market is down. The broad direction of the market contains a series of short term momentums. For example, when the direction of the market is up over the next 3-5 years, there will many occasions in between when the momentum will be negative. That should not be seen as a reversal of direction but merely as an opportunity to buy quality stocks in line with the upward direction.
Momentum versus direction: What you need to know
Here are 8 things you need to know about momentum and direction of the markets
Momentum refers to the trend of the stock or the overall market in the very short term. This is normally less than a period of 3 months and could be as short as a day. Momentum is normally a sub-cycle within the broader direction of the market. Direction, on the other hand, is slightly longer term in nature and pertains to a trend in the stock market over a 3-5 year period.
Momentum is typically driven by technical support and resistance levels as well as news flows, both domestic and international. Direction, on the other hand, is indicative of deeper and larger trends in the economy and industry. For example, disruption in telecom, RBI shifting to a dovish rate strategy are all factors that impact the direction of the market while monthly inflation, monthly IIP, quarterly results etc have an impact on momentum.
Momentum can normally be gauged using technicals. Charts and price ticks give you a good idea of which side the momentum is veering towards. Direction, on the other hand, requires in-depth fundamental analysis and an understanding of the larger implications of key trends at the industry and the company level.
Let us understand this concept of direction versus momentum with a live example. For example, the RBI indicating that it will cut rates will be a short term positive for sectors like NBFCs, real estate companies and MFIs. This will create positive momentum. But the shift in savings pattern in India in favour of financial assets over real assets is likely to create a positive direction for private banks and broking companies. According to the RBI deputy governor, Dr. Viral Acharya, this larger shift has been visible in India post demonetization.
An interesting concept here is understanding trading / investment strategy under different momentum conditions. When the momentum is positive but weak, then the strategy will be to buy the stock on each dip. On the contrary, when the momentum on the upside is strong, then the trader can look at aggressive long positions as well as additional leverage on the positions.
A similar case can be made for direction too. When the direction is positive and strong, then the strategy will be to aggressively go long on the stock. On the hand, if the direction is positive with a high level of risk, then the strategy will be to go long on the stock with an appropriate hedge. Alternatively, the investor can look to accumulate the stock gradually on each dip.
Momentum is normally measured using indicators like oscillators, stochastic, MACD, parabolic and many others. These are tools of technical analysis which are extensively used not only in understanding the momentum of the market but also to predict the turnaround points in momentum, which is when traders stand to make the most money.
Direction is measured through valuations ratios like P/E, P/BV and dividend yields. It also pre-supposes a thorough SWOT (strengths, weaknesses, opportunities, threats) analysis of the company and the competitive stage of the industry. It is only by understanding direction that an investor can generate alpha and outperform the market at large.
Both momentum and direction are extremely important from the stock market perspective. Both traders and investors need to have a larger understanding of momentum and direction so that they are not caught on the wrong foot. After all, that is what smart trading and savvy investing is all about!