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A Look at Odd Lot Shorts

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This measure of small-trader sentiment has been on a tear lately.

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Editor's Note: Minyanville is proud to premiere Professor Goepfert's new weekly column which will highlight actionable indicators.
I've been asked by Minyans to go over more of what I look at on a regular basis, and give feedback on common indicators that many of you have seen or heard about.
So each week, I'm going to highlight an indicator that I find useful. Most of them could broadly be categorized as being an attempt at measuring investor sentiment in one form or another, but I also monitor breadth and various types of price and seasonality patterns.
Some of the indicators I am going to cover I've written about before. Some are proprietary, but most are known and available from public data sources.
There is no particular order to what we're going to discuss each week. I want to keep it flexible in case I see something interesting develop, so we can keep things current and hopefully useful.
Let's start by taking a look at odd lot short sales.
WHAT IS IT?
The term "odd lot" references those trades executed for fewer than 100 shares at a time.
"Short sales" are those trades made by someone who borrows shares from someone else and then sells them, hoping to buy them back later (covering their initial sale) at a lower price. It's the exact opposite of a typical trade where we buy first and sell later, and it's a bet that the stock will fall in price.
Therefore, an odd lot short sale is a small-time bet on falling share prices.
WHY SHOULD WE FOLLOW IT?
It's difficult to find data where we have a good idea of who is doing what. Most sentiment data is mixed between individual and professional traders, including all types of trade sizes.
That's not really an issue with odd lot shorts. When we see a lot of these types of orders coming through, we assume that small traders are betting aggressively against a market rally. From a contrarian point of view, that should be bullish.
It should be, but is it justified? Well, yes, most of the time. Let's look at a current chart, with extremes in odd lot shorts highlighted.
WHAT DOES IT LOOK LIKE?
WHAT ARE THE CHALLENGES IN USING IT?
All sentiment-related indicators have one inherent difficulty – defining when exactly we've reached an extreme. There is no hard-and-fast rule that defines an extreme, and we have to use history as a guide to help us determine them.
Of course, whenever we use history we run into the possibility that times are changing (aka "it's different this time"), and old ranges no longer apply. To counter that, we can de-trend data, or use adaptive trading bands like we see above, and that helps alleviate some of those concerns.
With odd lot short sales in particular, there are questions as to the purity of the data. The increasing use of algorithmic trading, whereby orders are sliced and diced into small pieces in order to get the optimal execution, may be skewing these numbers. Also, there was a regulatory change in 2005 that made it easier for brokers to execute odd lot shorts.
WHAT'S IT SUGGESTING NOW?
We can see from the chart above that all of the recent extremes in shorting made Hoofy smile for at least a while. It would be ridiculous to suggest that these traders covering their shorts are causing subsequently higher prices, but we have the understanding that this indicator is a proxy for other activity that we cannot see.
On Friday, January 20th, odd lot shorts reached 4.9 million shares – a new all-time record. In fact, three of the top ten all-time readings occurred in the past week. That moderated with the rally the past few days, but it doesn't erase the fact that we've seen an extreme here and the market has (so far) obliged by working higher.
At many of the prior extremes in this indicator, what we have seen is a short-term bounce followed by one more push lower that establishes the final trading low. It wouldn't be out of the ordinary to see that once more.
This indicator has gone through periods of being absolutely useless and absolutely fantastic over the past 30 years. For the past few years it has done quite well and has been very helpful. If the market fails to consistently respond the way it has the past few years to these extremes, then we'll have an idea that it's time to put this one on the back burner once again, but that's not the case just yet.
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No positions in stocks mentioned.

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