What Is Cushion Theory?
Cushion theory argues that a heavily shorted stock's price, though it falls first, will again rise because the short-sellers must eventually purchase shares to cover their short positions. Of course, not all shares that fall in price will rise in the future - however, cushion theory suggests that stocks with very high short interest may have a greater probability of rebounding than those with low short interest, as there is more potential buying pressure that could result from short covering.
Short selling is a bearish trading strategy that speculates on the decline in a security’s price by borrowing and selling it on the open market, planning to buy it back later for less. Cushion theory argues that a heavily shorted stock’s price, though it falls first, will tend to rise because those short-sellers must eventually repurchase 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 (buying back those shares) eventually causes it to stop falling.
Key Takeaways
- 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.
- The evidence for cushion theory is mixed, and stocks that fall sharply, even with high short interest, may not rebound.
Understanding Cushion Theory
Cushion theory is based on the expectation that the accumulation of large short positions in a stock may cause the price to drop, with a rise that could follow due to the buying required by short-sellers. As investors move to cover short positions, the price of the stock may increase, implying a natural floor, or built-in “cushion,” to any short selling-induced decline. Therefore, stocks with high short interest are more likely to have such a cushion.
Short interest is a measure of how many shares of a stock are sold short relative to the total number of shares outstanding. It is usually expressed as a percentage or a ratio. A high short interest indicates that many investors are betting against the stock, which could mean that the stock is overvalued, facing fundamental problems, or subject to negative sentiment. A high short interest can also create an opportunity for a short squeeze, which is a sudden and sharp increase in the stock price due to a surge in demand from short sellers who are forced to cover their positions.
To identify stocks with high short interest, investors can use various sources of data, such as financial websites, stock screeners, brokerage reports, or exchange reports. These sources will often show stocks with a high short interest ratio (SIR), which is the number of days it would take for all short sellers to cover their positions based on the average daily trading volume.
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 Could Work
Cushion theory works because it assumes that there is a natural limit to how much a stock price can fall before short sellers start to cover their positions by buying back the shares they borrowed and sold short. This buying activity creates a demand for the stock and pushes its price up, creating a “cushion” that prevents further decline.
Cushion theory also implies that short sellers are a stabilizing influence on the market, as they provide liquidity, price discovery and risk management.
However, cushion theory does not guarantee that a stock price will always rebound after falling, as there may be other factors that affect the stock’s performance, such as fundamental problems, market sentiment or external events. Therefore, investors should not rely solely on cushion theory to make their investment decisions. Traders take bearish short positions in the expectation that a stock will fall and sometimes it does exactly that.
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.
Why Cushion Theory May Not Work
There is some empirical evidence for cushion theory, but it is not conclusive or consistent. Indeed, cushion theory might not work for several reasons. First, it assumes that short sellers will eventually cover their positions by buying back the shares, but this may not happen if they are confident that the stock price will continue to decline to effectively zero (i.e., go bankrupt) or if they have enough margin to withstand the losses.
Second, it assumes that there are no other factors that affect the stock price, such as fundamental problems, market sentiment or external events, that could outweigh the buying pressure from short covering.
Third, it assumes that short sellers are the only source of demand for the stock, but there may be other buyers who are interested in the stock for different reasons, such as value investing, dividend investing or contrarian investing.
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 maybe even rise. The phenomenon of a sudden sharp rise in a heavily shorted stock is also referred to as a "short squeeze."
What is the difference between a short squeeze and short covering?
A short squeeze is a situation where a rapid increase in a heavily shorted stock's price forces short sellers to buy back shares to close their positions, leading to further price increases. Short covering, on the other hand, is the act of closing out a short position by buying back the borrowed shares, which can contribute to a stock's upward movement. Short squeezes are characterized by intense buying pressure that results from forced short covering and can result in significant volatility, while short covering in and of itself is a regular part of short selling strategies.
What are the risks of selling short?
Short sellers are exposed to unlimited risk, since there is no limit to how high a stock may rise-but it can only fall to zero. Shorts must pay interest on the borrowed shares and dividends to the lender.
What is short interest theory?
Short interest theory is a contrarian view that states that high levels of short interest are a bullish indicator. Therefore, followers of this theory will seek to buy heavily-shorted stocks and profit from their anticipated rise in price. This approach goes against the prevailing view of most investors, who see short selling as an indication that the shorted stock is likely to decline.
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