September 21, 2020
The year 2020 goes down in history as the year in which the world faced a pandemic. However, financial market participants will also know that this year will be the year in which the stock markets recover the fastest after a bear market.
Once again, buying the downturn has worked. Who would have thought that the market would rise so quickly at the end of March? Who had the courage to buy? Here is an analysis of how the stock market works, what a bear market is, and how was it possible for such a rally to happen?
Trading on leverage
The stock market is the place where many fortunes have been made and will potentially continue to be made. It is also the place where many lose their last penny. Leverage amplifies the winners, but also the losers. Leverage trading means trading on borrowed capital. For example, suppose you are an optimistic Microsoft. And the price of a Microsoft stock is $100, just to simplify things, and you want to invest $10,000.
The broker offers you two options. You can either buy Microsoft shares at $100 (actually, fewer shares than that because you have to deduct commissions and fees), or you can use leverage. In the first case, if the price of Microsoft stock rises to $150 at the end of the year, the account has a balance of about $15,000. But what about trading on leverage?
Leverage means that the broker lends you money at a margin rate, and you can buy additional shares of Microsoft stock. This way, in a rally, you participate more in the rally. However, it is your responsibility to raise additional funds in case the stock price goes down instead of up. In addition, interest must be paid on the borrowed capital. Leverage is a common tool not only in the stock market, but also in the currency market.
Returning to the stock market rally, when the shares split in March, all traders using leverage received a margin call. Brokers sent out notifications that the margin had to be replenished. Failure to comply with this obligation results in the broker automatically closing positions. The vicious circle then began, and circuit breakers were triggered.
When the market falls more than twenty percent from its highs, it is said to enter bearish territory. In March, it broke a record.
However, the rapid rebound that followed reveals that short-term interest was greater at the peaks. The short or bears covered their positions at the lows. To do this, the broker buys back the borrowed shares from the trader who short-circuited them. In this way, he creates pressure on the long side.
In summary, one of the reasons why the stock market has bounced back so strongly is that there have been more short sellers than buyers at the lows. When sellers covered (i.e., made a profit), the market rebounded more than 20% from the lows, officially entering bull territory.