What Is the Odd Lot Theory?
Let me explain the Odd Lot Theory directly to you—it's a hypothesis in technical analysis that assumes small individual investors are usually wrong, and they're the ones most likely to make odd-lot sales. So, if you see odd-lot sales increasing and these small investors dumping a stock, that might be your cue to buy. Conversely, when odd-lot purchases are rising, it could signal a good time to sell.
Key Takeaways
- 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
I'm focusing here on how the Odd Lot Theory tracks the activities of individual investors who trade in odd lots. This approach assumes that professional investors and traders stick to round lot sizes—multiples of 100 shares—to keep their orders pricing-efficient. This idea was popular from around 1950 to the end of the century, but it's fallen out of favor since then.
Odd Lot Trades
Odd lot trades are simply orders from investors that involve fewer than 100 shares or aren't multiples of 100. These are generally from individual investors, whom the theory views as less educated and less influential in the market as a whole.
On the flip side, round lots start at 100 shares and are divisible by 100. These orders carry more weight as indicators because they're usually from professional traders or institutional investors.
You can track odd-lot trade volumes using technical analysis charting software, but tests since the 1990s show they no longer reliably signal market turns. In today's information age, even individual investors can make trades as informed as institutions. While the theory suggests following these investors for signals, it's become less relevant to analysts over time.
There are a few reasons for this shift. First, individual investors started putting more money into mutual funds, which funnel capital to institutional investors. Second, both fund managers and individuals turned to exchange-traded funds (ETFs), where high volumes are standard for popular ones.
A third factor is the rise in automation and computerization among market-making firms, plus the tech advancements of high-frequency traders. These have made order processing much more efficient overall, meaning odd lots get handled just as effectively as round-lot orders.
Testing the Odd Lot Theory
When researchers analyzed the Odd Lot Theory, especially wrapping up in the 1990s, they found it generally ineffective. It's hard to pinpoint if this is because individual investors aren't as prone to bad decisions or because institutional traders no longer avoid odd lots.
In the end, the theory isn't as valid as many researchers and academics once claimed. Burton Malkiel, known for popularizing the Random Walk Theory, has noted that the individual investor—or odd lotter—isn't as uninformed or incorrect as previously believed.
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