Shorting Stock 2 More on the mechanics of shorting stock.
Shorting Stock 2
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- Let's review what we went over in the last video, and one of
- you all actually commented that it would be a good idea
- to draw a timeline.
- So I'll draw a timeline.
- So we're learning about short selling.
- And in the last example-- let me do the timeline where
- things work out well for the short seller.
- So let me draw the stock price of IBM.
- Let me make this its-- OK, here we go.
- So let's say that this is-- that could be our timeline,
- it's by day.
- Let me draw the stock of IBM, it could look something like--
- that's my y-axis.
- Let's say the stock right now is at $100, it's trading
- someplace like that.
- And let's say it does that later, right?
- But we're sitting at this point right here-- we're
- sitting at, let's call this day 0.
- So what does the short seller do?
- So let's say the short seller, right now-- let me see if I
- can draw his balance sheet.
- So right now, the short seller, he has assets and
- His assets-- I won't worry about collateral requirements
- and all of that right now.
- But usually he already has to have some assets ahead of time
- for him to be able to borrow shares.
- But, actually-- let me give him some
- collateral ahead of time.
- So let's say that he already has $60 in his account.
- He has $60 of assets on day 0.
- And then this is the day that he says, you know what?
- I've done my analysis and I think IBM-- he doesn't see
- this part of the stock price, I mean, it would
- be great if he did.
- Then you could short with conviction.
- But all he sees is the past, right?
- If he did a stock chart he would just see-- let me switch
- colors-- he would just see this green part right here.
- He wouldn't see all the stuff that's in the future.
- But he has a lot of conviction that IBM is going to go down.
- So what he does is, he borrows a share of IBM on that day.
- So then on this day he borrows one share.
- So he has-- let's call that IBM-- one IBM.
- And he also owes one IBM.
- Right after you borrow it, before you do anything into
- it, you have it as an asset, and you also owe it back.
- And if you wanted unwind the borrowing of it, you could
- just give it back.
- But what he does at this point is he sells this IBM.
- He sells that share and he gets $100 for it.
- Because that was just the market price.
- That's what people were willing to trade IBM shares
- for at that point in time.
- That's day 0.
- Then let's say IBM reports its earnings, and
- they're really bad.
- And that happened on, I don't know, probably
- happened on this day.
- IBM reports.
- And the stock tends to go down, down, down.
- People take a long time to realize how
- bad the report was.
- And here at this day, once the stock has reached $50, our
- short seller says OK, that's enough.
- I don't think the stock's going to drop a lot more.
- So on day-- let's call this day 10.
- 10 days have gone by.
- Day 10, he decides to cover.
- So going into day 10, this is his balance sheet--
- let me redraw it.
- So going in to day 10, what does he have?
- He has $160.
- The $60 he had before, just by actually working.
- And he owes-- this is his asset, and his liabilities is
- he owes one share of IBM to the broker.
- And the broker really owes it to one of the shareholders of
- IBM who happened to be keeping the share with the broker.
- And he wants to cover.
- So what he does is, he takes $100-- no, no sorry, he
- doesn't take $100.
- Now shares of IBM only cost $50, right?
- So he takes $50 to buy a share, to buy one IBM.
- So instead of $160, he now has $110 and he
- has a share of IBM.
- And then what he does is, he takes this share of IBM and
- then gives it to the brokerage to pay off his liability.
- So then he's done.
- He's left with no liabilities, and just $110 of assets.
- So he made $50.
- So hopefully that clarifies it up a little bit, in that he
- sold here, and bought here.
- It's the reverse of a lot of stock, it's almost like you're
- acting in reverse time.
- But this was a very good scenario for the short seller.
- But he very easily could have made a blunder.
- Let's see what could have been a blunderous scenario.
- Let me draw a different stock chart for IBM.
- So let me draw the stock up to the day in question, and we
- said it was looking something like this, where it was
- trading right at around $100.
- And this is the day that our short seller decides to short
- it, and this happens.
- He essentially borrows a share of IBM.
- So he has a one IBM share liability.
- He sells that share and he collects $100.
- And then let's say IBM reports on this day, so this is day 0.
- Now IBM reports, and it's actually great.
- They did way better than anyone could have expected.
- So then the IBM shares skyrocket, and
- they go to this level.
- And at this point this-- and I'll talk more about short
- psychology and short squeezing, and all that-- but
- maybe here he's like, oh no, this is just a temporary blip,
- let me keep holding my position.
- But then the stock keeps going up and up and he says oh, this
- is just temporary, it's going to go back down.
- But at some point, his tolerance for pain has been
- tapped out.
- And let's say IBM gets to $150.
- He says, I can't handle this anymore.
- And I think you're already noticing a very negative
- dynamic or a highly risky dynamic that occurs with
- shorts, is that you can lose an arbitrary amount of money.
- Because what's happening now?
- Let's say he wants to cover it right now.
- This is day 10 in this alternate universe.
- So now, what are his assets and his liabilities?
- Going in to day 10, his asset, we said, was $160.
- Because he had short sold, he had $160.
- But he owes one share of IBM.
- For him to unwind this, to pay back the share of IBM, what
- does he have to do?
- He has to go out into the market and buy a share of IBM
- at this higher price, at $150.
- So when he goes out, instead of $160 he has to use 100-- so
- he has $10-- and then he uses $150 of that to go buy-- $150
- of the $160 to buy a share of IBM.
- So then he gets a share of IBM.
- And then he can pay that share back to the broker and cancel
- out his position.
- And he's left with just $10.
- So in this scenario when the stock price rose by
- $50, he lost $50.
- So he sold low and then he bought high, right?
- And the really risky thing that maybe is apparent to you
- now about short selling is that his loss
- could have been infinite.
- What if IBM, instead of going to $150, what if went to $200?
- Then he would have lost $200-- if it went to $200, he would
- have lost $100.
- If it went to $300, he would have lost $200.
- So his loss isn't just the amount of the
- original short position.
- It isn't just the $100 or whatever the original
- price of IBM was.
- It can be an infinite amount, so it really can kill your
- balance sheet.
- Or really make you broke.
- While when you go in the long side of things, if I were to
- buy IBM here.
- Let's say I'm the guy that bought this share from the
- short seller.
- What's my worst case scenario?
- Well the worst thing I can have happen is that the share
- of IBM goes to 0.
- So my loss is really, I can just go to 0.
- I won't end up owing someone an infinite amount of money.
- So short selling, inherently, because of this infinite, you
- could say downside to the short seller, right?
- They can lose an infinite amount of money.
- They have to be really careful about how they make their
- positions and how they protect themselves from this
- And we'll talk a little bit about things like margin
- requirements and things like that in the future, that
- essentially make sure-- are the broker's way of making
- sure that the short seller can actually-- is good to buy back
- the shares.
- Anyway, see you in the next video.
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