What Is Cushion Theory?

Cushion theory posits that a heavily shorted stock's price, while it falls at first, will again rise because the short-sellers must eventually purchase shares to cover their short positions.  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.

In social economics, cushion theory may refer to a country having social safety nets like social security or national health insurance, which provide residents with needed support.

Key Takeaways

  • Cushion theory argues that heavily shorted stocks have a natural bottom due to the fact that all short sellers must eventually cover their shorts.
  • The term "cushion" is used to convey a natural limit to the extent to which a stock may fall before it bounces back somewhat.
  • Implicit to the cushion theory is the investment view that short sellers are a vital, stabilizing influence, contributing to the efficient functioning of financial markets.

Understanding Cushion Theory

Cushion theory is based on the expectation that while the accumulation of large short positions in a stock may cause the price to drop, a rise will eventually follow due to the buying that short-sellers must do. As investors move to cover short positions to book profits or stop losses by purchasing shares, the price of the stock will have to increase. In other words, there's a natural floor, or built-in "cushion," to any short selling-induced decline.

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.

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—that is, who buy a stock expecting its price to go up. Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.

Why Cushion Theory Works

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' prices 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.

Technical analysts who subscribe to cushion theory consider it particularly encouraging if the short positions in a 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

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, the company has already commercialized a number of 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.

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 the bad news is limited and share price declines are abating, they would cover their short positions, causing the stock price stabilize and rise. In fact, the stock price might rise quickly and sharply if drug trial results are positive and short-sellers are forced to cover.