What Is the Odd Lot Theory?
The odd lot theory is a technical analysis hypothesis based on the assumption that the small individual investor is usually wrong and that individual investors are more likely to generate odd-lot sales. Therefore, if odd lot sales are up and small investors are selling a stock, it is probably a good time to buy, and when odd-lot purchases are up, it may indicate a good time to sell.
- Odd-lot trades refer to orders involving shares less than a round lot of 100 shares.
- These odd-lot trades are thought to be made predominantly by individual retail traders who are likely less informed participants in the market.
- Odd lot theory advises trading against these uninformed traders' activity.
- Testing of this hypothesis seems to indicate that this observation is not persistently valid.
Understanding the Odd Lot Theory
The odd lot theory focuses on following activities of individual investors trading in odd lots. This hypothesis also assumes that professional investors and traders tend to trade in round lot sizes (multiples of 100 shares), to improve pricing efficiency in their orders. Although this thinking was common lore from about 1950 until the end of the century, it has since become less popular.
Odd Lot Trades
Odd lot trades are trade orders made by investors that include less than 100 shares in the transaction or are not a multiple of 100. These trade orders generally encompass individual investors that the theory believes are less educated and influential in the market overall.
Round lots are the opposite of odd lots. They begin at 100 shares and are divisible by 100. These trade orders are seen to be more compelling as an indicator as they are typically made by professional traders or institutional investors.
Although technical analysts have the ability to follow the volume of odd-lot trades through technical analysis charting software programs, testing since the 1990s shows that these kinds of trades no longer seem to signify market turns. Given the information efficiencies of the information age, even individual investors may be just as likely to make an informed trade as an institutional trade. While the odd lot theory implies that these investors may be more important to follow for trade signals, this concept has become less important to analysts over time.
There are multiple reasons for this. The first reason is that individual investors began investing more heavily in mutual funds, which pool money into the hands of institutional investors. Secondly, fund managers and individuals alike began using exchange-traded funds (ETFs), with large volume being normal for the most popular ETF offerings.
A third reason is the increased automation and computerization of market-making firms and the increased technology of high-frequency traders. Together, these factors have created an environment where order processing has become far more efficient. The greater efficiency of the markets has meant that odd lots are not processed any less effectively than round-lot orders.
Testing the Odd Lot Theory
Analysis of the odd lot theory, culminating in the 1990s, seems to disprove its general effectiveness. Whether because individual investors are not generally prone to making bad investment decisions, or because institutional traders no longer fear making trades in odd lots is not easily determined.
Overall, the theory is no longer as valid as many researchers and academics once opined. Author Burton Malkiel, credited for popularizing Random Walk Theory has stated that the individual investor, also known as the odd lotter, is generally not as uninformed or as incorrect as had been previously thought.