If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:9:32

Video transcript

you've probably heard the tour the term short sale and have a at least a general Oh what did I do with that there I did I scroll down and 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 now know where IBM is trading right now but let's say IBM IBM is right now it's the last trade was at $100 that's $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 right 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 judgement right now but I want to know if there is 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 make draw some diagrams so this is my brokerage this is my broker and I mean this is me right here this is me I have a top hat anyway so I go to the broker and say broker I would like to short IBM I would like let's just say for for simplicity I want to short one share of IBM so what I do is I go to the broker and 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 on to ative for me the first time I learned about the notion of borrowing a share but you could also view it as renting a share and you might say well where's the broker getting it from well this broker has got a ton of clients right let me draw some of them his eyes were strange okay 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 brokers always has you know all of let's say each of these as 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 er 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 a hundred dollars right and then if IBM issues a dividend if it says okay all of our shareholders will get five dollars from the companies and then each of these guys would get five dollars 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 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 said broker I want to borrow a share of IBM the broker says okay well you know I have all these shares sitting down sitting around here and they're really not doing anything I'll lend you these this share right there and stick it in my account and I'm gonna have to pay rent to borrow that share you can kind of view it as either interest on the on the you know on borrowing the share you could view it as rent rent is sometimes more intuitive because whenever we talk about you know when you when you rent someone's apartment you're really kind of borrowing their apartment and 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 right anyway I think you get the ideas but I'll borrow this and you'll say hey wait Sal that doesn't make sense how can you just borrow this guy stock right 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 so 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 okay give this stock to this guy a whoops it's 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 security 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 you know it's beneficial to them and the broker you know 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 you know I originally borrowed this guy share this guy wanted to sell his share so that the broker does is he takes this share gives it to him and now I have officially borrowed this guy share right this is the share I've borrowed now because this one's been sold now what happens if IBM issues a dividend it says every one of our shareholders should get five dollars well this guy is expecting a $5 check right or he expects $5 to be deposited in his brokerage account for that to happen I essentially have to write this guy the $5 check so I have to make it look or at least a broker the brokerage is going to force me to make it look like this guy still owns the sitch the share so anything that this guy gets by being a shareholder of this stock I have to provide for him anyway so I 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 said it's trading right now at $100 I've borrowed this share I've borrowed the share so I sell it so let's see the first thing as I borrow 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 so I sell 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 I have what's my current state of affairs 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 oftentimes 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 I'd have to pay $100 well no the share of IBM stock prices dropped to $50 so actually let me do that I'm not paying $100 out I'm going to pay $50 out I'm going to pay $50 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 I'll give it back to my brokerage so I will see I will go out spend 50 get back a share and then give that share back to the brokerage and 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 use 50 of this hundred to buy the shares back so how much do I have left I have $50 left and $50 left and I return the shares of IBM so I have nothing I don't won 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 right you want to buy low sell high sell high when your short selling you're doing it you're doing the same thing but you're doing in Reverse you want to sell high 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 of more about what you know this was a very good scenario where it happened what 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