shamebear (shamebear) wrote in quants,

On short-selling and control theory

Short-selling of stocks got a lot of bad press from the current financial crisis, but I found a comment from a control engineer interesting. In ordinary buying and selling, everyone hopes that the value of the stock will keep on rising and he likended this to a positive feedback loop, which cannot be stable. The short-selling was then to be the negative feedback loop which by control theory design gave the system stability.

It's an intriguing idea, but I can't see that the analogy holds true. Booms and crises are better seen as excessive fluctuations than anything heading towards infinity and excessive fluctuations exist in control systems as well, especially if there's time-lags involved.

And in any case, dosn't every transaction involve people with different beliefs? The seller bets that his money can be spent better elsewhere and the buyer bets that the same amount is best spent on the stock, so they must have different beliefs about where it or other stocks are heading?
The same goes for short-selling, where you'r betting against someone and the short-selling may actually produce extra financial instruments so that even short-selling indirectly fuels the race of those that think the stock prices will rise.

Still, it seems to make sense at least to try framing the stock market in terms of control theory. Has anyone come across better expositions in this direction?
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Good point. A sale options (*) for instance, can be both an insurance and a short-selling gamble.

Another signal that a stock is overpriced is of course that people don't want to buy it, but far as I know you can't count "won't-byers" or even how many wanted to buy a given stock from available market data, so short-selling would seem to make the state of the market more visible.
Though perhaps a working futures market does much the same thing?

*) if that's the right translation. The right to sell a stock you have, in the future at a fixed price.