2020 remains in history as the year the world faced a pandemic. However it will also be known to financial market participants as the year with the fastest stock market recovery following a bear market.
Once again, buying the dip worked. Who would have thought that the market will rise so fast in the late days of March? Who had the courage to buy? Here is an analysis of how the stock market functions, what is a bear market, and how come that such a recovery was possible?
Trading on Leverage
The stock market is the place where many fortunes were made and potentially will continue to be made. It is also the place where many lose their last penny. Leverage amplifies winners, but also the losers. Trading on leverage means to trade on borrowed capital. For example, let’s assume you are bullish Microsoft. And, the price of a Microsoft share is $100, just for the sake of simplicity. Also, you want to invest $10,000.
The broker gives you two options. You can either buy $100 shares of Microsoft (actually fewer shares than that, because you must deduct for commissions and fees) or use leverage. In the first instance, if Microsoft’s share price rises to $150 at the end of the year, the account shows a balance of $15,000 approximately. But how about trading on leverage?
Leverage means that the broker lends you money at a margin rate, and you can buy additional shares of Microsoft. Therefore, on a rally, you participate more at the rally. However you are responsible for coming up with additional funds in the case the shares decline in price, instead of rising. Moreover, there is interest to be paid on the borrowed capital. Leverage is a common tool not only in the stock market but also in the currency market.
Coming back to the stock market rally, when stocks divided in March, all traders using leverage received a margin call. Brokers sent notifications that the margin needs to be replenished. Failing to do so triggers closure of the positions automatically by the broker. And so the vicious circle started, and circuit breakers were triggered.
When the market falls by more than twenty percent from the highs, it is said it enters bearish territory. It did so fast in March that it broke the record.
However, the quick bounce that followed reveals that there was more short interest at the highs. Shorts or bears covered their positions at the lows. To do so, the broker buys back the shares borrowed to the trader that shorted them. Thus, creating pressure on the long side.
To sum up, one of the reasons that the stock market bounced so strong was that there were more short-sellers than buyers all the way down to the lows. When sellers covered (i.e., booked profits), the market bounced more than 20% from the lows, thus officially entering the bullish territory.