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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's say you don't like company ABCD very much and you're convinced that the stock is going to go down. So in that situation, you can actually short the stock, which in a very high level is a bet that the stock is going to go down. And the way that you do that mechanically is that you borrow the stock from someone else who owns it, and then you immediately sell that stock that you don't even own. You sell the stock that you borrowed from someone else, and you'll sell it at the current price. So, for example, in this situation, you would sell it at the current trading price of $50. You would then hope that the stock price goes down. Let's think about the situation where the stock price goes down. So if you shorted it right over here, you borrowed the stock and you sold it for $50. And then if the stock were to actually go down-- let's say it goes all the way down to $20, and you think that's about how far it's going to go down, then you can buy back the stock for $20 in this situation. And then give it back to the owner. You had borrowed the stock. Now you can hand back the stock to the owner. So you could give it back and you've essentially unwound it. And what it allowed you to do is it allowed you to do the buying and selling in reverse order. Normally before you sell something you have to buy something. But here you were able to sell it and buy it later for a lower price. So the situation where the end price is $20 you had sold it for $50. So you got $50. And then you had to use $20 of it to buy it back. So in that situation, shorting the stock, you would have made $30. Let me write this column here. This is the short option. You sold at $50. You borrowed and sold at $50. Then when it went down to $20 you bought it back for $20. So you had $50 of proceeds. You had to use $20 of it to buy it back. So you had a $30 profit. But that's only in the good scenario. What happens if your bet is wrong? What happens if the stock price goes up to $80? And over here you get so scared. You're like, oh my god, I have to buy the stock back by $80. What if it keeps going up? I could lose an unlimited amount of money. So over here you get scared and you unwind your situation. You say, OK, I'll go and buy the stock for $80, so I can give it back. So in this situation where the stock goes up you actually could lose a lot of money. You had sold it for $50. So you only have $50 that you have from the transaction. But now you have to buy the stock for $80. So if you sold for $50 and you buy for $80 you've now lost $30. You're $30 in the hole. So now you are at negative $30. And really shorting is the riskiest of all of the things you can do, because a stock price and go unbelievably high. What happens if the stock price goes to $800 or goes to $8,000? All of a sudden, you've sold something for $50 and you have the obligation at some point in the future, because you have to give the stock back, of paying $500, or $800, or $8,000. You don't know how much you'll have to lose. So it's really the riskiest thing you can do. But it is one way to bet that a stock price will go down, or profit from a stock price going down.