What is odd lot theory?
The odd lot theory is a technical analysis hypothesis based on the assumption that the small individual investor is generally 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 stocks, this is probably the right time to buy, and when odd lot purchases are up, it may indicate a good time to sell. .
Key points to remember
- Irregular batch operations are groupings of shares less than a round batch of 100 shares.
- These irregular lot transactions are believed to be perpetuated by individual traders who are viewed as less likely market participants.
- The test of this hypothesis seems to indicate that this observation is not always valid.
Understanding the odd lot theory
The odd lot theory focuses on the following activities of individual investors trading in odd lots. This assumption also assumes that professional traders and investors tend to negotiate round lot sizes (multiples of 100 stocks) in order to improve price efficiency in their orders. Although this thought was a common tradition from around 1950 to the end of the century, it has since become less popular.
Irregular batch operations
Irregular lot trades are trade orders issued by investors who include less than 100 stocks in the transaction or which are not a multiple of 100. These trade orders generally include individual investors who are theorized to be less educated and influential in the market in general.
Round lots are the opposite of odd lots. They start at 100 stocks and are divisible by 100. These trade orders are considered a more convincing indicator as they are usually issued by professional traders or institutional investors.
Although technical analysts have the capacity to monitor the volume of irregular lot transactions using graphical analysis software, tests carried out since the 1990s show that this type of transaction no longer seems to mean market reversals. Given the effectiveness of information in the information age, even individual investors can be just as likely to make an informed trade as an institutional trade. Although the odd lot theory implies that these investors may be more important to follow for trading signals, this concept has become less important to analysts over time.
There are several reasons for this. The first reason is that individual investors have started to invest more in mutual funds, which put money in the hands of institutional investors. Second, fund managers and individuals have started using exchange-traded funds (ETFs), with large volumes 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 much more efficient. The greater efficiency of the markets has ensured that odd lots are not treated less efficiently than round lot orders.
Odd Lot Theory Tests
Analysis of the odd lot theory, culminating in the 1990s, seems to refute its general effectiveness. Whether it is because individual investors are generally not inclined to make bad investment decisions, or because institutional traders are no longer afraid of trading in odd lots is not easy to determine.
Overall, the theory is no longer as valid as many researchers and academics once thought. Author Burton Malkiel, credited for popularizing Random Walk Theory, said that the individual investor, also known as an odd lotter, is generally not as misinformed or as incorrect as previously thought .