Cushion Theory

Remember "playing superhero" as a kid? You’d stand on the arm of the couch, towel tied around your neck as a cape, and do a Superman jump off the side. Which way did you jump? Toward the hard floor? Or toward the soft, forgiving cushions?

We’re guessing you avoided enough head trauma to be able to read this...meaning you chose the cushions. The key concept here: something falling onto a cushion...bounces.

Okay, fast forward a few decades from the kid with the cape. Now you’re a Wall Street superhero. There’s a stock that’s been heavily shorted. Which means there’s a lot of money bet on the stock going down. To short a stock, a trader borrows shares and sells them. Then they hope to repurchase the shares at a lower price and return them to the person they borrowed from in the first place.

It’s important here to note that the act of closing out the short involves buying stock.

Now to cushion theory itself, which says a stock that’s heavily shorted can only decline so much before it bounces. It’s going to hit a cushion eventually.

Why? Because as it goes down, the people shorting the stock have to buy shares to book a profit. This buying causes upward pressure on the stock...which creates the cushion.