Learn about Shorting Stock Video

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Learn about Shorting Stock

You’ve probably heard the term short sale and have at least a general, oh what did I do with that, there it is, I scrolled 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 all of the stock market crashes or what's happening with banks. But I thought it would be worthwhile to at least explain what a short sale is. And then we can 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 lets say that IBM, I don’t know where IBM is treating 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 its going to fall to $50 based on my deep stock analysis. And so the general idea is that is should, well I wont make any value judgment right now but I want to know if there's a way that I can make money out 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 broker and this is me right here. This is me, I have a tap 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 simplicity, I want to short 1 share of IBM. So what I do is I go to a broker and say, broker can I borrow a share of IBM and this is a little unintuitive the first time people are to buy is 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, where does the broker get it from. Well these brokers got a ton of clients. Let me draw some of them. His eyes were strange. 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 all of, let say each of this 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 and maybe this guy would thought depending on how it’s done and then this will be replaced with the money and this would become $100. And then if IBM issues a dividend, if it says, okay all of our shareholders will get $5 from a company’s and then each of these guys will get $5. 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 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 said, broker I want to borrow a share of IBM. The broker says, okay I got all these shares sitting down, sitting around here and they're really not doing anything. I’ll lend you the share right there. Let’s take it into my account. And I'm going to have to pay rent to borrow that share. You could kind of view it as either interest on borrowing the share, you can view this rent. Rent is sometimes more intuitive because whenever we talk about, when you rent someone’s apartment, you 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 got the ideas. But I’ll borrow this. And you say, hey wait Sal that doesn’t make sense. How can you just borrow this guy stock? I mean this guy might want sell it the next day. And that’s a good question. If this guy wants to, lets say I borrowed his stocks, its not sitting there anymore, if this guy wants to sell his stock the second after I borrowed it, the broker is going to take his, he’s just going to shuffle around stocks a little bit, I mean 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 I’ll just get this stock to this guy, oops 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 security so that none of these guys ever know that their stock has borrowed. Although you have to get permission especially if these guys own the stock outright, they have to give permission to let the stock be borrowed if 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 it can keep shuffling around. And we’ll talk about what happens if you actually tried to do this with the share that you’ve never borrowed. We’ll do that in a future day. 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 lets say I borrowed these guys, lets say I usually borrow this guy share, this guy wanted to sell his share so that the broker does is he takes this share, give it to him, and now I’ve officially borrowed this guy’s share. This is the share I borrowed now. This one’s been sold. Now what happens if IBM issues a dividend? It says everyone of our shareholders should get $5. Well this guy is expecting a $5 check. 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 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 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 out of that? So I set this trading right now to $100. I borrowed the share so I sell it. So let’s see the first thing is I borrow 1 share that I’ve done there. And now I sell it on the market and you said it’s selling for $100. I sell it for $100. I sell it to the market. Let’s say the market is out here to 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 1 share of IBM. Let’s say my analysis ends up of 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 1 share of IBM and how much do I have to pay out, I have to pay $100? Well no, the share of IBM stock price is dropped to $50. So actually, let me do that, I'm not paying $100. I'm going to pay $50 and I'm going to get back a share of IBM. And that what I owe, so I 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. This guy’s never knew that anything happened. And in the process what happened? I sold all the shares for $100 and I bought them back for $50. So after unwinding this whole thing, I used $50 of this hundred 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've made $50 off of this trade. So traditionally in the stock market, on the long side, you want to buy low, sell high. When you’re short selling, you’re doing the same thing but you’re doing 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 of more about what, this is a very good scenario where I wanted to happen did happen. But in the next video we will 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.

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You’ve probably heard the term short sale and have at least a general, oh what did I do with that, there it is, I scrolled 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 all of the stock market crashes or what's happening with banks. But I thought it would be worthwhile to at least explain what a short sale is. And then we can 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 lets say that IBM, I don’t know where IBM is treating 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 its going to fall to $50 based on my deep stock analysis.

And so the general idea is that is should, well I wont make any value judgment right now but I want to know if there's a way that I can make money out 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 broker and this is me right here. This is me, I have a tap 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 simplicity, I want to short 1 share of IBM. So what I do is I go to a broker and say, broker can I borrow a share of IBM and this is a little unintuitive the first time people are to buy is 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, where does the broker get it from. Well these brokers got a ton of clients. Let me draw some of them. His eyes were strange. 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 all of, let say each of this 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 and maybe this guy would thought depending on how it’s done and then this will be replaced with the money and this would become $100.

And then if IBM issues a dividend, if it says, okay all of our shareholders will get $5 from a company’s and then each of these guys will get $5. 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 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 said, broker I want to borrow a share of IBM. The broker says, okay I got all these shares sitting down, sitting around here and they're really not doing anything. I’ll lend you the share right there. Let’s take it into my account. And I'm going to have to pay rent to borrow that share. You could kind of view it as either interest on borrowing the share, you can view this rent. Rent is sometimes more intuitive because whenever we talk about, when you rent someone’s apartment, you 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 got the ideas. But I’ll borrow this. And you say, hey wait Sal that doesn’t make sense. How can you just borrow this guy stock? I mean this guy might want sell it the next day. And that’s a good question.

If this guy wants to, lets say I borrowed his stocks, its not sitting there anymore, if this guy wants to sell his stock the second after I borrowed it, the broker is going to take his, he’s just going to shuffle around stocks a little bit, I mean 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 I’ll just get this stock to this guy, oops 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 security so that none of these guys ever know that their stock has borrowed. Although you have to get permission especially if these guys own the stock outright, they have to give permission to let the stock be borrowed if 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 it can keep shuffling around. And we’ll talk about what happens if you actually tried to do this with the share that you’ve never borrowed. We’ll do that in a future day. 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 lets say I borrowed these guys, lets say I usually borrow this guy share, this guy wanted to sell his share so that the broker does is he takes this share, give it to him, and now I’ve officially borrowed this guy’s share. This is the share I borrowed now. This one’s been sold.

Now what happens if IBM issues a dividend? It says everyone of our shareholders should get $5. Well this guy is expecting a $5 check. 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 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 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 out of that? So I set this trading right now to $100. I borrowed the share so I sell it. So let’s see the first thing is I borrow 1 share that I’ve done there. And now I sell it on the market and you said it’s selling for $100. I sell it for $100. I sell it to the market. Let’s say the market is out here to 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 1 share of IBM. Let’s say my analysis ends up of 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 1 share of IBM and how much do I have to pay out, I have to pay $100? Well no, the share of IBM stock price is dropped to $50.

So actually, let me do that, I'm not paying $100. I'm going to pay $50 and I'm going to get back a share of IBM. And that what I owe, so I 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. This guy’s never knew that anything happened. And in the process what happened? I sold all the shares for $100 and I bought them back for $50. So after unwinding this whole thing, I used $50 of this hundred 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've made $50 off of this trade.

So traditionally in the stock market, on the long side, you want to buy low, sell high. When you’re short selling, you’re doing the same thing but you’re doing 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 of more about what, this is a very good scenario where I wanted to happen did happen. But in the next video we will 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.

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