 Hello and welcome to the session in which you would look at short sales. Just what we talked about in the prior session about buying on margin, which was a risky endeavor. This is another risky endeavor, short sales. The topic is covered in essentials or principles of investment, either graduate or undergraduate. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them. Put them in playlists. If they benefit you, it means they might benefit other people. Connect with me on Instagram. On my website, farhatlectures.com, you will find additional resources to complement and supplement your accounting as well as your finance courses. Check out my website if you are studying for your CFA, CPA, CMA, or just simply for your courses. What is the big idea with the short sales? And there is a famous book called The Big Short. I spoke about this book in this series when I talked about the housing crisis. And it's basically The Big Short. Here, what they did, the investors or the speculators that undertook this strategy, they shorted the market. What does short mean? Short means you anticipate the market to go down. Therefore, what you do, you sell it first. You sell the market, you anticipate it to go down, then you buy it when it's cheaper. So that's that's the idea. So if you are bullish on a stock, bullish means you are optimistic. If you like a stock, if you think it has a good prospect, you buy. You buy the stock, then you sell when it's higher. That's the idea, then you sell. If you are bearish, bearish means if you are pessimistic, if you don't like something, you think the future is not good for that something, you go short. It means you sell now and you buy later. It's the opposite. Huh? Yes. Well, I don't have anything to sell. Well, you borrow it and you sell it immediately and you keep the cash. We'll see how it works. Okay. So this is when you do a short sale, a short sale, the sale of shares not owned by the investor, but borrowed through a broker and later purchase to replace them. So this is how it works. First you sell, then you buy the shares later. So the short seller first borrowed the shares from the stock broker, then sells it at a later date. Okay. But remember, later you have to buy it. So what is the risk? The risk is huge. The risk is a huge. Why? Because you anticipate the stock to go down. The maximum the stock could go down to zero. Okay. So if you, if you shorted a stock that's trading at 65, it could go down to zero. You could make a profit of 65. You shorted a stock at 65. This stock could, in theory, could go up to infinity. And if it goes, if it goes to infinity, you have to buy it at infinity prices. So your risk is very, very high when you short a stock. Okay. Then when you buy it back, it's called short, covering short position. So when you buy that stock to give it back to the broker, this process is called you are covering your short, covering short position. And sometime what happened when the stock market some days, the stock market goes up substantially and they would say part of it is short covering. What does that mean? It means people who are shorting certain stocks, now they are forced to buy it back. Now, why are they forced to buy it back? You will see in a moment because they have a maintenance call. They are forced to buy it back. When they buy it back, they even push the stock price higher. It's like basically burning themselves because as they buy more, the stock goes up. Okay. So let's take a look at a picture of what we are talking about here. So normally, most likely what you are familiar with is when you buy the stock, when you buy the stock at time zero, you have a negative cash flow, you buy the stock and you have to pay for it. Then later, at period one, later on a month a year, you would receive a dividend if you waited long enough and you sell the shares. Then you get back your ending price plus the dividend. So that's the normal investing, if you're not called a normal. So basically your profit is your ending price plus the dividend minus what you paid. So if you paid $100 for a stock, you got $2 in dividend and you sell it for $105, you have a profit of $7. So this is how you made the profit. When you short a stock, it's kind of the opposite. Well, you do at time zero, you borrow and sell and then you have cash in your pocket. Let's assume you borrow and sell and you have $100,000 cash in your pocket. Here's what's going to happen. At year one, later on in the future, you'd have to do two things. You have to pay any dividend to the person that you bought, you got the, you borrowed the share from and you have to replace the stock. So let's assume that you had to pay dividend of $1,000. Well, you have to pay dividend of $1,000, but you bought the shares at $100,000. Now the shares are only worth $80,000. And now you have in your hands $100,000. You have $100,000. You have to pay, you have to, you buy the stock at $80,000. You pay the shareholder another $1,000. You made a profit of, you made a profit of $19,000. I made the profit looks really good on short selling. Make sure you don't do it. This is pretty risky, but that's the point. Okay. That's the point if you make a profit because you could also, what could happen is the price, the ending price of the stock could go up to $120,000 and you only have $100,000. So you always take a huge risk. You always take a huge risk with the short sale. Remember, you anticipate the stock to fall so you can buy it at a lower price. And remember, you have to pay the dividend. You have to buy back the share and you have to repay the dividend. Okay. In practice, this is how it works in practice. So the shares loaned out for a short sale are typically provided by a short, by the short sellers brokerage firm. So you borrow it from your broker. So if you have a Schwab account, Schwab will provide it to you. Now what Schwab do usually, you don't know this is happening. They borrow it from another account. And that's all what happened. Now, when they borrow it from your account, they don't tell you they borrowed the stock because if you want to sell your stock, they will immediately get it from someone else and they will give it to you. Okay. So the owner of the shares need not to know that the shares has been leant out to short sellers. If the owner wishes to sell, the broker will get the shares from somewhere else or from their own inventory. Okay. So the short sale may have an indefinite term because it keeps on, it could keep on going forever. If the brokerage firm cannot locate new shares to replace the ones sold, usually that's not the case. The short seller will need to repay the loan immediately by purchasing the shares in the market. That usually doesn't happen, but in theory, it could happen. No firms would, would, would force you to do that. Also, the exchange rules require that proceeds from a short sale must be kept in the account of the broker. So you cannot short sell something, get the money and take it somewhere else, another brokerage firm or do something else with it. So the short seller cannot invest these funds to generate income, although large or institutional investors typically, typically receive some income from the proceeds of the short sale being held with the broker. But that's, you know, that's, we're talking about large investors. Short sellers are also required to post-mortem. And this is important, which is collateral, cash or collateral, either you have cash or you have other securities with the broker to cover losses should the stock rise during the short sale. So what happened if the stock price keep on rising, you are more and more under pressure. So what's going to happen is the broker, the broker's risk is, look, if this stock goes up too much, this individual will never buy it back and they will walk away and they will never buy it back and will have to buy back the share. So what they do is they make you post a margin. And in case the price went up too high, they'll ask you to even post more margin or sell or give them back the money. Okay, so suppose you are pessimistic on a dot com stock and it's market price right now is $100 and you don't think you think it's going to go down. So what you do is you tell your broker to sell short 1000 shares, the broker will borrow 1000 shares either from another customer or from another broker. And now what you have, you have $100,000 cash in your, in your, in your account. Why? Because you shorted 1000 shares at $100. Now suppose also suppose the broker has a 50% margin requirement on short sales. In other words, you have to have $50,000, 50% of 100,000 is 50,000, either in cash or in some other assets. We're going to assume you have those in Treasury Bill. Okay, so it means you have, you have to have $50,000 in some form or another in assets. Okay, so let's say you have them in Treasury Bill. So this is what your balance sheet looks like when this transaction takes place. You have $100,000 cash in your pocket. From, from the short, but remember you borrowed those 100,000 because you sold the stock. Therefore, you have to buy back this 1000 shares. And right now your liability today is 100,000. You have $50,000 in Treasury Bill. This is a neuron account. Therefore assets minus liabilities equal to equity of $50,000. Therefore you have equity of $50,000. Your initial percentage is the ratio of the equity in the account, 50,000 to the current value of the shares. So simply put just like the buying on account. It's the equity divided by the value of the shares. The equity is 50,000 divided by the value of the shares right now. The value of the shares are $100,000. Okay. So the, so the percentage margin is 50%. Okay. Now suppose that the dot-com stock went down to 70. So let's suppose the dot-com stock went down to 70. Now, will you be happy about this? Of course you will be happy because that's your whole goal. Your whole goal is the stock to go down because you have 100,000. Now to buy the stocks, you only need 70,000. So you can keep the remaining, the profit. You can buy the stock, give it back to the share, give it back to the broker and pocket the 30,000. So to cover, to cover the short sale, you buy the 1000 shares, which is going to cost you 70,000 now and you keep the profit. Okay. Because your account was credited 100,000 when the shares were borrowed and sold, your profit is 30,000. So your profit equal to the decline in the share price times the number of shares short. Because remember, a decline by 30, you have 1000 shares, you made $30,000 profit. Now you have to be very careful. Again, why? Because, because when you're selling short, the price could go against you rather than 70, go down to 70, it could, it could rise. Okay. Like investors who buy stocks on a margin, a short seller must be concerned about a margin call. So if the stock price rises, the margin call, the margin, the, the margin in the account will fall. So your value will fall. So if the margin fall to a maintenance level, you either have to sell your position or bring some cash because you're going to have what's called a margin call. Okay. Suppose the broker has a maintenance margin call of 30% on short sales. This means the equity in your account must be at least 30% of the value of the short position at all time. So the value should be, so the value of the equity, the numerator divided by the value of the stock has to be at least 30%. So, so how do we find out what is the price for the stock? So let, let's be, we don't know what the P is. Let P be the price of the dot stock, dot com stock. The value of the shares, the value of the shares you must pay back is 1000 shares times P, the price, which is, we don't know. And the equity in your account, remember you have 150,000, the equity is minus 1000 shares times P because you have to buy back the share. So your short position in the equity, your short position margin ratio is equity divided by the value of the stock, your equity, which is 150,000 minus 1000 shares times P divided by the value of the shares, the value of the stock 1000 shares times P. So this is what it looks like. So now you're looking, we want to find out if the margin maintenance is 30%, how much can that, can the stock price increase, not drop, because remember your, your, your concern, it's going to increase. Well, what you do is you, is you solve for P and if you solve for P, we'll find out that the price will be one hundred fifteen dollars and thirty eight cents. Simply put, if the, if the price went up to one fifteen thirty eight, this maintenance will be 30%, then you have to either come up, now you have, you have to do one of two things. You can either bring more cash to increase this one hundred and fifty thousand, okay, because you want, by increasing this, you increase this, or you have to sell your position or some of your position. So if the dot com stock rises above one fifteen, you'll get a margin call and you'll either have to put up additional cash to cover or cover your short position by buying shares to replace the one owned. Simply put, you have to close your position. Once you buy shares, means you are closing your position. Now, what happened if the maintenance called rather than 30, they said for, for this broker, for this brokerage firm, it's point four or 40 under those circumstances, as soon as the price increases to 107.14. So if the, if the margin, if the maintenance margin is 40%, you could do the computation, notice the higher the margin, the, the lower the sensitivity. It means if the stock goes up a little bit, you're gonna, you're gonna have a margin call, okay? And you can try 45% if you want to find out, you know, the stock price will be like lower than 107. Let's construct the balance sheet. If the dot com stock went up to 110, let's look at this balance sheet of the stock price goes up to 110. Well, this was the original balance sheet that we looked at. When, when we bought the stock, we had 100,000 of cash because when we, we shorted the stock at 100, we had 50,000 in Treasury bill, our liability is to buy back 1000 shares at this point. They are 100, 100 per stock, which is 100,000 and our equity is assets minus the liability. What they're saying here is let's assume the stock goes up to 110. What would happen if the stock goes up to 110? Well, here's what's gonna happen. This 100,000 becomes 1000 shares times 110 equal to 110,000. So this is equal to 110,000. As a result, this is your cash will stay 100,000. Your cash did not move. Your Treasury bill still 50,000. What's gonna happen? Your equity will be eating by 10,000. So for every, so every time your, the stock goes up by the same amount, your equity goes down. Okay. Why? Because as the stock goes up, it's going against your position. Your position is the stock to go down and it's going up. So this is what happened if the stock goes up to 110 and you could do the same thing if it went up to 120 and you could do the same thing if it went down to 90. If it went down to 90, then this becomes 90 and you add 10,000. This becomes 60. Okay. So your equity would increase. If the short position maintenance is 40%, how far can the stock rises before the investor gets a margin call? We already did this computation. I believe it was $107 in some change, but you can do it yourself if you're interested. As always, I'm gonna remind you to like this recording, share it, put it in playlist. In the next session, we'll look at investment companies. As always, I would like to remind you to visit my website farhatlectures.com. If you are studying for your accounting courses, finance courses, or your professional certification, good luck, study hard and stay safe.