Cushion Theory
What Is Cushion Theory?
Cushion theory posits that a vigorously shorted stock's price, while it falls from the outset, will again rise in light of the fact that the short-sellers must eventually purchase shares to cover their short positions. A "cushion" hence exists since there is a natural limit to the degree to which a stock might fall before short covering eventually makes it stop falling.
In social economics, cushion theory might allude to a country having social safety nets like social security or national health care coverage, which give occupants required support.
Figuring out Cushion Theory
Cushion theory depends on the expectation that while the accumulation of large short situations in a stock might make the price drop, a rise will eventually follow due to the buying that short-merchants must do. As investors move to cover short situations to book profits or stop losses by purchasing shares, the price of the stock should increase. At the end of the day, there's a natural floor, or underlying "cushion," to any short selling-prompted decline.
Implicit to the cushion theory is the investment view that short venders are an indispensable, stabilizing influence who add to the efficient working of financial markets.
Short selling is a trading strategy that estimates on the decline in a security's price. Basically mirroring a bearish view, it stands out from investors who go long — that is, who buy a stock anticipating that its price should go up. Short selling happens when an investor gets a security and sells it on the open market, planning to buy it back later for less money.
Why Cushion Theory Works
Because of reasons either established in fundamentals of a company or technical analysis of a stock, shares of a company might be sold short by traders or investors. The hope is that the shares' prices will fall and the short sales will be covered, conveying gains to the short-venders. Watching from the opposite side of the trade are investors, who buy into the cushion theory that, sooner or later, the shares will end up in a seemingly impossible situation and eventually move back up when short dealers cover their situations by buying the stock.
Except if a company is really made a beeline for a financial disaster, similar to bankruptcy, any short-term challenge experienced by a company is normally settled, and the stock price ought to mirror the new stability. The hypothetical cushion prevents exorbitant downside loss for investors who go long on the stock.
Technical analysts who buy into cushion theory consider it especially reassuring in the event that the short situations in a stock are two times as high as the number of shares traded everyday — making it more probable that short merchants should cover their positions rapidly, guaranteeing to a greater degree a rise in the shares' price.
Illustration of Cushion Theory
Assume, for instance, that a drug company with another medication going through a clinical trial will before long release interim data. The stock of the company is shorted by large institutional investors who think that the data won't arrive at statistical significance in adequacy. Nonetheless, the company has proactively popularized a number of revenue-creating drugs and has more in its development pipeline. In this way, even on the off chance that the cynics are proven right, and can cash in on a short-term drop in the stock, buyers who stick to the cushion theory, could likewise benefit when the stock is bought back.
Fundamentally, the buyers don't accept that this single trial disappointment will totally unwind the value of the company and are waiting for the short venders to realize this also. When the short dealers perceive the terrible news is limited and share price declines are subsiding, they would cover their short positions, causing the stock price balance out and rise. As a matter of fact, the stock price could rise rapidly and pointedly on the off chance that drug trial results are positive and short-venders are forced to cover.
Highlights
- Cushion theory contends that vigorously shorted stocks have a natural base due to the way that all short dealers must eventually cover their shorts.
- The term "cushion" is utilized to pass a natural limit on to the degree to which a stock might fall before it quickly returns fairly.
- Implicit to the cushion theory is the investment view that short merchants are an indispensable, stabilizing influence, adding to the efficient working of financial markets.
