What is Cushion Theory?

Cushion theory posits that a heavily shorted stock's price must eventually rise as the short sellers will have to buy back to cover their positions.

Key Takeaways

  • Cushion theory posits that a heavily shorted stock's price must eventually rise as the short sellers will have to buy back to cover their positions.
  • The term "cushion" is used to convey that there is a natural limit to the extent to which a stock may fall before it bounces back.
  • Implicit to the cushion theory is the investment view that short sellers are a vital, stabilizing influence who contribute to the efficient functioning of financial markets.

Understanding Cushion Theory

Cushion theory is based off the expectation that the accumulation of large short positions in a particular stock will ultimately lead to an increase in the price of that stock, buoyed by the buying demand that will arise when these 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 book profits, or stop losses, the price of the stock will be have to increase. Implicit to the cushion theory is the investment view that short sellers are a vital, stabilizing influence who contribute to the efficient functioning of financial markets.

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 on 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, who adhere to the cushion theory, could also benefit when the stock is bought back.

Basically, the buyers do not believe that this single trial failure will completely unravel the value of the company and are waiting for the short sellers to come to this realization as well. Once the short sellers recognize that the extent of the price declines are abating, then 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.