DEFINITION of Cushion Theory

Cushion theory is the expectation that the price of a stock that has been heavily shorted will eventually rise if or when the short positions are covered. A "cushion" exists because there is a natural limit to the extent to which a stock may fall before it bounces back. As investors rush to cover short positions to stop losses or book profits, the price of the stock will be pressured to increase.

BREAKING DOWN Cushion Theory

For reasons either rooted in fundamentals of a company or technical analysis of a stock, shares of a company may be sold short by traders or investors. The hope is that the shares will fall and the short sales will be covered, delivering gains to the short sellers. Watching from the other side of the trade are investors who subscribe to the cushion theory that at some point the shares will hit bottom and eventually move back up when short sellers cover their positions by buying the stock. Unless a company is truly headed toward a financial disaster like bankruptcy, any short-term challenge experienced by a company is usually resolved, and the stock price should reflect the new stability. The theoretical cushion prevents inordinate downside loss for investors who go long the stock.

Suppose, for example, that a pharmaceutical company with a new drug undergoing a clinical trial will soon release interim data. The stock of the company is shorted by large institutional investors who think that the data will not reach statistical significance in efficacy. However, since the company has already commercialized a number of revenue-producing drugs and has more in its development pipeline, even if the doubters are proven correct and can cash in on a short-term drop in the stock, buyers informed by the cushion theory could also benefit when the stock is bought back. The buyers do not believe that this single trial failure will completely unravel the value of the company and that because short sellers would also recognize this probability, they would cover their short positions, causing the price of the stock to stabilize and move up. Staying with this example, the stock price could even rise quickly and sharply if the drug trial results are positive and short sellers are forced to scramble to cover.