What Is Cushion Theory?
A "cushion" thus exists because there is a natural limit to the extent to which a stock may fall before short covering eventually causes it to stop falling.
- Cushion theory argues that heavily shorted stocks have a natural bottom because all short sellers must eventually cover their shorts.
- The term "cushion" conveys a natural limit to the extent a stock may fall before it bounces back.
- Cushion theory implies that short sellers are a stabilizing influence on financial markets.
Understanding Cushion Theory
Cushion theory is based on the expectation that the accumulation of large short positions in stock may cause the price to drop, with a rise that will eventually follow due to the buying required by short-sellers. As investors move to cover short positions, the price of the stock will increase, implying a natural floor, or built-in "cushion," to any short selling-induced decline.
Short selling is a trading strategy that speculates on the decline in a security's price. Essentially reflecting a bearish view, it contrasts with investors who go long, those who buy a stock expecting its price to increase. Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less.
Why Cushion Theory Works
For reasons rooted in the 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' prices will fall and the short sales will be covered, delivering gains to the short-sellers. Investors that subscribe to the cushion theory anticipate the shares will hit bottom and eventually move back up when short sellers cover their positions by buying the stock.
Unless a company is headed toward a financial disaster, like bankruptcy, any short-term challenge experienced by a company is usually resolved, and the stock price should stabilize. The theoretical cushion prevents inordinate downside loss for investors who go long on the stock.
Technical analysts who subscribe to cushion theory consider it particularly encouraging if the short positions in the stock are twice as high as the number of shares traded daily making it more likely that short sellers will have to cover their positions quickly, ensuring more of a rise in the shares' price.
Example of Cushion Theory
A pharmaceutical company with a new drug undergoing a clinical trial is set to release interim data. The stock of the company is shorted by large institutional investors who believe the data will not reach statistical significance in efficacy.
However, the company has already commercialized several revenue-producing drugs and has more in its development pipeline. So, 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.
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 realize this. Once the short sellers recognize the limit of the bad news and share price declines are abating, they would cover their short positions, causing the stock price to stabilize and rise. This phenomenon is also referred to as a "short squeeze."
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