The Odd Lot Short Ratio (“OLSR”) is a market sentiment indicator that displays the daily ratio of odd lot short sales compared to odd lot buy/sell transactions.
Investors “short” a stock in anticipation of the stock’s price falling. Instead of the traditional transaction of buying at a lower price and profiting by selling at a higher price, the short sale transaction is just the opposite. To profit from a short sale, the stock must be sold at a higher price and bought (covered) at a lower price An “odd lot” short is a short sale transaction involving less than 100 shares.
If we could find an investor who was always wrong and do the exact opposite of him, we would always be right! Odd lot indicators strive to do just that. If we assume that small investors (“odd lotters”) are inexperienced (and thus usually wrong), then trading contrarily to the odd lot traders should be profit-able.
The higher the OLSR indicator, the higher the percentage of odd lot shorts and the more likely the market will rise (proving the odd lotters wrong). Similarly, the lower the OLSR, the more likely a market decline.
Generally this rule (invest contrarily to the odd lotters) has held true. Odd lotters tend to be reactive rather than proactive. High Odd Lot Short Ratios tend to come after major market declines (when investors should be buying, not selling) and low readings usually come after long market advances.
In 1986, the number of odd lot shorts reached levels that were unheard of. The explanation I have heard for this is that specialists are placing multiple odd lot short orders to avoid the up-tick rule which states that a short order must be processed on an up tick. They do this on days with major declines in prices.
If this explanation is true, it drastically complicates the interpretation of all odd lot indicators. It would mean that the odd lot indicators show what the “littlest” guy is doing, except when it reaches extreme readings in which case it would show what the “biggest” guy (the members) is doing.
Refer to the examples inside the explanation of the Odd Lot Balance Index and Odd Lot Purchases/Sales.
The Odd Lot Short Ratio is calculated by dividing the number of odd lot short sales by the average number of odd lot transactions for the day. (Because odd lots do not necessarily have a buyer and a seller for every transaction, we calculate the average number of transactions by adding the number of odd lot buy orders with the number of odd lot sell orders and then dividing by two.)