Cushion Theory: What it is, Does it Work?

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.

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.

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.

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."

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