How Short Selling Works

the big short is probably one of the most popular films on the topic of investing it's a star-studded movie that follows the real story of three groups of people who short or bet against the

housing market for billions of dollars right before the 2008 real estate crisis as you might expect our heroes end up making quite a bit of money but how exactly does a short work well in the

movie the positions are taken through what are known as swaps a derivative agreement that is taken with the banks but for common investors short positions typically involve individual stocks make

them easy enough to take but be warned shorting comes with a lot of risks on top of charging you expenses you don't normally see with standard investing shorting also offers a skewed payoff

where you face a limited upside in an uncapped downside meaning you could lose an infinite amount of money theoretically anyway so before you decide to short something let's go over

the strategy in the risks involved on today's plain bagel [Music] shorting also known as short selling is a trading strategy where an investor

sells a security today and buys it back in the future hoping that the price of the security will go down it's effectively the opposite approach to a traditional long position where investors buy today and sell at some

point in the future to cash in hopefully after the price has gone up it follows the same buy low sell high mentality as long investing but it just reverses the order of the motto so

investors sell high today and hope that the price will go down so they can buy low in the future now shortening on a stock is a bit more complicated than going long on a position so let's go through a running

example to explain how the strategy works in the risks it poses imagine you have to investors who decide to take opposite positions in plain bagel Co the company stock currently has a market

price of $10 investor a decides to buy 1,000 of these stocks thereby investing $10,000 one investor B decides to short 1,000 stocks thereby selling 10,000 dollars worth of

the investment now I know what you're thinking how the hell do you sell a stock that you don't own well oftentimes the process involves selling a borrowed security for example in a brokerage

account you can often sell a position by borrowing a stock from your broker and then shorting that way leaving you with the proceeds from the sale the money you make from the sale obviously doesn't

really belong to you since you sold someone else's stock to get it but eventually when you buy the security back known as covering your short you'll be able to return the stock and keep whatever money is left over which is how

you profit from the trade so going back to our example the stock price falls from $10 to $5 investor a will lose $5,000 one investor B will gain $5,000 since they'll be able to buy the stock

back for a lower price and keep the remaining sales proceeds on the other side of things if the stock price increases from ten to fifteen dollars investor aid will be up five thousand dollars while investor B will be down

five thousand but this raises an interesting question up until this point investor B hasn't actually contributed any of their own money so how is he going to buy back the stock for more money than what's in the

account well this is where the concept of margins come into play you see too short a position an investor needs to post what's known as an initial margin a 50% into their account to act

as a buffer should the investment lose value this means that investor B would have contributed five thousand dollars of his own funds at the beginning of our example to accommodate for any losses

the amount still belongs to the investor but it's held as collateral by the broker to ensure that investor B can afford to buy back the share in the future investor B will also be responsible for what are known as margin

calls a process that occurs when the margin becomes insufficient for example in the event that the share price rises to $15 investor B would receive a margin call to replenish their cash buffer

based on what's known as the maintenance margin since there's no more wiggle room in the account to accommodate for further losses so a big difference between shorting and going long a position is that you can only short in a

margin account while this has its downsides it does add leverage to the investors return what do I mean by that well let's go back to our example let's say that our share price falls from 10 to 5

dollars this would leave investor aid to lose $5,000 an investor be to gain $5,000 on an absolute basis these returns equate one another but on a percentage basis taking into account

margins they're actually quite different you see investor a has lost roughly 50% of their investment but since investor B has only contributed five thousand dollars of his own money to this margin

account he's actually gained 100 percent of his investment doubled the percentage of investor a because borrowing is involved with shorting investor B will see his returns amplified though this

goes both ways percentage losses in the short position will be double what they might have been for investor a so will decline a 50% for investor a would translate into a one

hundred percent decline for investor B so short positions not only flip the percentage return received by investors but they also amplify them both on the way up and the way down but here's where

we get into the distinct disadvantages of a short position namely short positions come with unique costs that a standard long investor won't face for example if the stock you borrow pays a

dividend you'll actually need to pay this amount to your broker meaning that you'll face a cost equal to whatever dividend the stock pays short positions also charge investors in interest rate on the value

of the stock you borrowed after all since you are borrowing and selling someone else's security you need to compensate them in the same way that you would compensate a bank with interest on a loan

typically the rate charge on a short position can range anywhere from 2.5 to 20 percent but it can be higher for what are known as hard to borrow stocks highly volatile or small cap positions

so needless to say shorting the stock can be quite a bit more expensive than a simple buy but for the most part these expenses are fair the interest makes sense since you are taking a leveraged

position and since you are trying to inverse the return of a long position it's only natural that you pay out the dividend received from the stock but there are some absolute disadvantages involved with the short

strategy some of which may very well turn you off the idea of ever trying to short a stock for one short strategies face what's known as buy-in risk the chance that a broker will make you

prematurely cover your position this can occur for a number of reasons a broker may need to return a stock to the portfolio they took it from or the stock may simply see a surge in demand but the

end result is that you may be forced to close your position at any time this is a pretty significant drawback especially when it comes to waiting out market volatility in our example perhaps

investor B is confident that certain factors whether it be regulation or technological change will cause the stock to crash in two years time but if the price surges in the near term they

may be forced to realize a loss even if they end up being right on top of this when shorting a position you may experience what's known as a short squeeze when a heavily shorted stock sees its price surge because the

investors shorting the stock need to cover their physician since investors who short sell have a appropriately shorter time horizon than long investors this is a chance that they buy back the

stock around the same time which can lead to a surge in the price and make it harder for you to cover your own position without realizing a loss so as you can see there are some distinct

disadvantages with shorting a position which alone may lead you to stay away but perhaps the biggest risk with short positions has to do with their skewed payoff with her to investors longing in

shorting the $10.00 stock we face to risk reward profiles on the one hand investor a can theoretically earn an infinitely high return the $10,000 investment in the ten dollar stock could

double triple quadruple in value as the stock price climbs to 20 30 $40 or higher on the downside the most she can lose is the money she's invested the

$10,000 which would only happen if the stock fell to 0 a pretty drastic outcome now investor B actually flips the risk reward here if the stock drops down to 0 ignoring fees they can achieve a 200%

return since they are able to keep the $10,000 your profits from their $5,000 investment on the other hand if the stock instead climbs to 20 30 $40 or

higher they can lose 200 400 600 percent or more this means that you can lose a lot more money than what you've initially invested and indeed this very

feature has had devastating impacts on the investors this is why many investors tend to stick with long lonely positions for many of the return is simply not worth the risk and on top of the fact that you're going against the natural

upward bias of stocks you're more or less betting against a company that is actively trying to prove you wrong short selling certainly does play an important role in the world of investments and indeed you can make a lot of money by

placing the short bet against a deteriorating stock but if you're looking to speculate with short selling tread lightly you may end up buying off a lot more than you can chew thanks for watching if you like this video make sure to hit the like button and if you

like what we're doing here make sure to subscribe give a like on it if you want notifications about future videos if you have any feedback or topics you want me to cover in a future video leave a comment down below for the plain bagel my name is Richard coffin thanks for

joining me today [Music] you