Do odd lot trade execution orders indicate potential predatory behavior on the part of the trader? Potentially, according to a new white paper released by Credit Suisse.
Most stock trades occur in round numbers, 100 shares, 500 shares, etc. In fact, according to recently-disclosed data from the SEC, only 5% of share volume occurs in odd lots, non-rounded numbers such as 117 or 648, for instance. Why would anyone use odd lots? Credit Suisse presents three popular theories – some maliciously-minded, some benign.
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This is part nine of a ten-part series on some of the most important and educational literature for investors with a focus on value. Across this ten-part series, I’m taking a look at ten academic studies and research papers from some of the world’s most prominent value investors and fund managers. All of the material Read More
Make sniffing cheaper
The report notes that odd lots can be “just another tool that ‘predatory’ traders can use to prey on “real” investors.” The notion of “sniffing” to identify a large institutional order to then use that knowledge to jump in front and profit at the institution’s expense has been widely publicized. While it’s easy to spread theories without actually confirming them, the Credit Suisse report identified evidence of the practice (see HFT – Measurement, Detection, and Response).
The logic suggests that since sniffing involves sending orders and reading any fills that come back, it is logical to assume that traders doing this would prefer to spend less money, hence the impetus to use odd lots. Taken to the extreme, the least costly – and therefore most popular – order size will be only 1 share. And in fact we do see a concentration of 1-share trades (see Exhibit 1) – potentially damning evidence indicating the high frequency abusers, the report noted.
The “Unbundling” Theory
The second theory is that odd lots can be used to unbundle even lot institutional orders and thus avoid regulatory reporting apparatus.
US market structure is built on even lots, the report notes, and odd lots are not covered by 2005’s seminal Regulation NMS. This means that odd lots, while included in exchange order books and even slotted in the price priority queue, are not “protected”. They do not actually appear in the publicly displayed quote stream, thus they cannot establish the National Best Bid and Offer (NBBO). NBBO is the bid and ask price the average person will see. The Securities and Exchange Commission’s Regulation NMS requires that brokers must guarantee customers this price.
“The theory goes, abusers could intentionally send odd lot orders to break up the displayed round lots at the top of the book and manipulate the NBBO, which many ATS’s use to price their trades,” the report notes. “Of course, this activity is explicitly outlawed as ‘odd lot unbundling.’”
Retail can’t afford a round lot
The third reason traders may use odd lots is more benign. The basic fact is that many retail investors cannot afford round lots and place odd lot orders. With the average price of a stock in the S&P 500 around $75, a round lot costs around $7500, the report notes. For popular stocks like Apple that trade over $500, a lot costs $50,000 while a round lot of Google requires over $100,000. This is “likely much more than many retail investors even have at their disposal” and suggests “not only should we expect to see more odd lots among retail investors, but also that we should see more odd lots in higher priced stocks.”
Odd lot trades part of market structure
The report concludes that odd lot trades should not necessarily be considered predatory. “Whether or not HFT is engaging in predatory strategies, our data suggest that any evil activity may not be as widespread as some might believe based solely on hearing the high odd lot rate as reported by the SEC and disseminated by the media,” the report noted. “Mixed lots – popular with institutional investors trading a fixed notional – and odd lot residuals – which are created even from round lots – are behind many of these odd lot trades.”