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Shorting stock 2

More on the mechanics of shorting stock. Created by Sal Khan.

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Video transcript

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. Short. 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 liabilities. 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? 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. Right? 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 eventuality. 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.