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Video transcript
You've probably heard the term short sale, and have at least a general-- oh, what did I do with that? Oh there it is, I scrolled down-- you probably have a general idea that it means, to some degree, making a bet that a stock will fall. And there's been a lot of news lately that maybe short sellers are to blame for a lot of the stock market crashes, or what's happening with banks. So I thought it would be worthwhile to at least explain what a short sale is. And then we could talk a little bit about whether they're positive or negative, or they could be both. So you are right if you think that a short sale is some type of a bet that a stock can go down. But how does it work? So let's say that, I don't know, IBM-- and I don't know where IBM is trading right now-- but let's say IBM is right now-- the last trade was at $100. And I'm convinced. I've done my research, I've done my analysis, and I'm just convinced that the stock price of IBM is going to fall. I think IBM is going to have a horrible quarter next quarter. That some other competitor is going to take their business, whatever. I'm convinced it's going to fall to $50. This is what I think. I think it's going to fall to $50, based on my deep stock analysis. And so, the general idea is that I should-- well I won't make any value judgment right now-- but I want to know if there's a way that I can make money off of my deep analysis. And the way I do that is I go to my brokerage-- so let me draw some diagrams. So this is my brokerage, this is my broker, and this is me right here. This is me. I have a top hat. Anyway, so I go to the broker and I say broker, I would like to short IBM. I would like-- let's just say for simplicity I want to short one share of IBM. So what I do is I go to the broker, and I say broker, can I borrow a share of IBM? And this is a little unintuitive the first time people learn about it. It was a little unintuitive for me the first time I learned about the notion of borrowing a share. But you can also view it as renting a share. And you might say well, where's the broker getting it from? Well this broker's got a ton of clients. Let me draw some of them. His eyes were strange. OK, so this broker has a ton of clients, many of whom own IBM. And they keep their shares of IBM with the broker. So the broker always has-- let's say each of these is a share of IBM. And these guys are all owners of IBM. And if ever, one day, this guy wanted to sell his share of IBM, the broker would go out there, sell it in the market, or maybe this guy would sell it, depending on how it's done. And then this would be replaced with the money, and this would then become $100, right? And then if IBM issues a dividend, if it says OK, all of our shareholders will get $5.00 from a company. And then each of these guys would get $5.00. So they're all just shareholders in the company. And also, just so you know, as opposed to being short the company, they're long. When you go long [? on a ?] security, you're buying the security. When you go short, as you'll see, you're borrowing the security and selling it. So let's see how that works. So once again I go to my broker and I say broker, I want to borrow a share of IBM. And the broker says OK, well I've got all these share sitting around here. And they're really not doing anything. I'll lend you this share right there. And stick it in my account. And I'm going to have to pay rent to borrow that share. You can kind of view it as either interest on borrowing the share, or you can view it as rent. Rent is sometimes more intuitive. Because whenever we talk about when you rent someone's apartment, you're really kind of borrowing their apartment. Then you can kind of view the rent as the interest on the apartment. Or the other way to view it, when you borrow money, the interest is kind of rent on the money. Anyway, I think you get the idea. But I'll borrow this. And you'll say hey wait, Sal, that doesn't make sense. How can you just borrow this guy's stock? I mean, this guy might want to sell it the next day. And that's a good question. If this guy wants to-- let's say I borrow his stock, it's not sitting there anymore. If this guy wants to sell his stock the second after I borrow it, the broker is just going to take-- he's just going to shuffle around the stocks a little bit. I mean, you know stocks are-- they call it fungible, you can replace one stock certificate with the other. They're no different. So then he'll say OK, I'll just give this stock to this guy. Whoops. I just messed up with my pen. I'll just give this stock to the guy who wants to sell it, and then you would have essentially borrowed from this guy. And you could keep rearranging the securities so that none of these guys ever know that their stock is borrowed. Although you have to give permission, especially if these guys own the stock outright. They have to give permission to let the stock be borrowed, and they benefit, because they get some cut, hopefully, they get some cut of the rent, or the interest that I'm paying. So it's beneficial to them. And the broker can never, well it should never, really, lend out all of the shares here. Just so that it can keep shuffling around. And we'll talk about what happens if you actually try to do this with a share that you've never borrowed. We'll do that in a future thing. But the general idea is, you borrow one of these shares out here, and then the broker can kind of keep shuffling around these shares, if any of these guys really want to get rid of their share. And let's say I've borrowed this guy's. Let's say I originally borrowed this guy's share. This guy wanted to sell his share. So what the broker does is, he takes this share, gives it to him, and now I have officially borrowed this guy's share. Right? This is the share I'm borrowing now because this one's been sold. Now, what happens if IBM issues a dividend? It says every one of our shareholders should get $5.00. Well this guy's expecting a $5.00 check. Or he expects $5.00 to be deposited in his brokerage account. For that to happen, I essentially have to write this guy the $5.00 check. So I have to make it look, or at least the broker is going to force me to make it look like this guy still owns the share. So anything that this guy gets by being a shareholder of this stock, I have to provide for him. Anyway, so I've borrowed the stock. Now what do I do with it? My whole thesis here is that IBM is going to $50, so how do I make money off of that? So I [? set ?] [? this ?] trading right now at $100. I've borrowed this share. So I sell it. So let's see, the first thing is I borrow one share, as I've done there. And now I sell it on the market. And we said it's selling for $100. I sell it for $100. So I sell it to the market. Let's say the market is out here to the left. So I sell to the market, and I get $100. So let's see what's happening right now. What's my current state of affairs? Let's say assets-- and I'll talk about margin requirements later-- liabilities. What do I have, what do I owe? So now I have $100. And what do I owe? I owe one share of IBM. Let's say my analysis ends up being correct, often times it won't. And we'll talk a little bit more about why short selling can be extremely risky. But let's say my analysis is correct, and a couple of days later IBM starts trading at $50. What I can do now is unwind my trade, or cover my short. And the way I do this, is I have $100, right? What I can do is, I can then just go out there and buy my shares of IBM back, right? So I buy one share of IBM. And how much do I have to pay? Do I have to pay $100? Well no, the share of IBM stock price has dropped to $50. So actually, let me do that. I'm not paying $100 out, I'm going to pay $50 out. And I'm going to get back a share of IBM. I'm going to get back a share of IBM, and that's what I owe. So I'll give it back to my brokerage. So I will go out, spend $50, get back a share, and then give that share back to the brokerage, give it back to that guy. These guys never knew that anything happened. And in the process, what happened? I sold the shares for $100, and I bought them back for $50. So after unwinding this whole thing-- I used $50 of this $100 to buy the shares back. So how much do I have left? I have $50 left. And I returned the shares of IBM, so I owe no one anything. So I made $50 off of this trade. So traditionally in the stock market, on the long side you want to buy low, sell high, right? When you're short selling, you're doing the same thing, but you're doing it in reverse. You want to sell high and buy low. Anyway, hopefully that gives you the general idea of the mechanics of short selling. In the next video I'll talk a little bit more about what-- this was a very good scenario, where what I wanted to happen did happen. But in the next video we'll talk about the risks of short selling, and maybe a little bit of a discussion of whether it really is good or bad for the markets, or for society as a whole. See you in the next video.