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Current time:0:00Total duration:8:43

Video transcript

let's review what we went over in the last video and one of y'all actually commented that it would be a good idea to draw a time line so I'll draw a time line short so we're learning about short selling and in the last example let me do the time line where things work out well for the short seller so let me draw the stock price of IBM let me make this it's let me see maybe draw fairly think alike okay here we go so let's say that this is Plus that could be our time line that's by day let me draw the stock of IBM it could look like something like I mean just that's my y-axis let's say the stock right now is that $100 it's trading someplace like that and I you know and let's say it does that later right but we're sitting at this point right here we're sitting it let's say it go let's call this day zero day zero so what does the short seller do so let's say the short seller right now let me see if I could draw his balance sheet so right now the short seller he has assets and liabilities so a short seller short seller 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 some collateral ahead of time so let's say that he already has I don't know he has 60 dollars in his account he has sixty dollars of assets on day zero and then this is the day that he says you know what I've done my analysis and I think IBM he had 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 you did a stock trade he would just see let me do 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 here so then on this day he borrows one share so he has what's called that IBM one I be M and he also owes one IB heõs one IBM right right went 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 to 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 a hundred dollars 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 zero then let's say you know IBM reports its earnings and they're really bad and that happened on I don't know probably happened on this day IBM reports IBM reports and the stocks 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 is going to drop a lot more so on day let's call this day 10 I know 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 into day 10 what does he have he has 160 dollars the $60 he had before just you know 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 so 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 one IBM so instead of 160 he now has 110 dollars 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 clears up Claire I sit up a little bit and that he sold here and bought here right it's the reverse of you know 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 and let's see let's see what could have been a blunder Asst scenario so 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 was trading right at around $100 and this is the day that our short seller decides to shorted and this happens right he essentially borrows a share of IBM so he has a 1 IBM share liability he sells that share and he collects $100 and then let's say IBM reports you know IBM IBM reports on this day so this is day zero day zero 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 the the and I'll talk more about short psychology and short squeezing and all that but maybe here he's like oh no you know 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 dollars and 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 date this is day 10 in this alternate universe so now what are his assets and his liabilities going into day 10 his asset we said was he had $160 because he had shorts sold he had $160 but he owes one share of IBM one I B M 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 what he goes out he goes instead of $160 he has to use 100 so he has $10 and then he uses 150 of that to go by 150 of 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 right what if IBM instead of going to 150 what if I went to 200 then he would have lost $200 what if it if I went to 200 he would have a he would have lost $100 if it went to 300 he would have lost $200 so his loss isn't just the amount of you know your 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 you to really make you broke well when you go on the long side of things you know if I were to buy IBM here let's say you know I'm the guy that bought this share from the short seller what's my worst case scenario well I go the worst thing I can happen is that the share of IBM goes to zero so my loss is really you know I can just go to zero I won't end up owing someone you know 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 eventualities and we'll talk a little bit about things like margin requirements and things like that in the future that essentially makes sure are the brokers way of making tuffnut make sure of making sure that the short seller can actually is good - but to buy back the shares anyway see you in the next video