What is Cushion Theory?

Cushion theory is a concept in investment holding that the price of a stock with large short positions will eventually increase, as investors move to purchase it for the purpose of covering their short positions. It refers to that which many investors have sold for some time. Such stock usually creates upward pressure causing investors to engage in buying the shares on sale, leading to high demand.

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How Does Cushion Theory Work?

Cushion occur because of the natural limit caused by a stock's price decrease before bouncing back. Investors usually move to purchase the stock in order to cover short positions. This way, they can either avoid losses or book profits. The demand puts pressure on prices leading to its increase. Note that if many investors take short positions in the stock, the price will rise. It is because the positions need to be covered by stocks purchases. The company's shares are likely to be sold short by investors or traders based either on the stocks technical analysis or a company's fundamentals. They do this with the hope that there will be a fall in the shares, leading to covering of short sales that will eventually deliver profits to the short-sellers. However, looking at this from the other angle, investors or traders that subscribe to this theory believe that the shares will eventually bounce back at some point when short sellers buy stock to cover positions. So, unless a firm is truly headed towards a financial crisis such as bankruptcy, it is possible to resolve any short-term challenges that it may experience. The company's stock price should be able to show the new stability.

How Cushion Theory Works

Lets assume that there has been heavy shorting of stock. It means that there is likely to be much money because of the decrease in stock. So, to short a stock, investors decide to borrow shares so that they can resell them. They hope to repurchase the shares at a reduced price and then return them to the owners. Note that to be able to close out the short, there must be buying of stock. Now according to cushion theory, there is an assumption that the stock that is heavily shorted has to decline first before bouncing back. It means that it will hit the cushion at some point. Why is this so? It is because when it declines, the investors shorting the stock will have to purchase the shares to book a profit. This purchase is what causes stocks upward pressure, hence creating what we call cushion.