Position Limit (Derivatives) - Explained
What is a Position Limit?
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What is a Position Limit?
A position limit is the ceiling placed on the number of derivative contracts, such as options or futures contracts, which may be held by an individual trader or affiliated group of traders. This ceiling is determined by the US Commodity Futures Trading Commission and/or the exchange upon which the particular contracts are being traded. An individual investor or a combined group of investors are not allowed to exceed that limit.
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How Does a Position Limit Work?
A Position Limit ensures that no single individual trader or group of traders can hold a huge number of contracts for a specific security. This restriction prevents the manipulation of market price. If an investing party gets hold of a huge number of a specific security, it gives them the power to manipulate the options market. In general, the position limits are too high for an individual trader to reach. Without a position limit in place, the large investors or funds would have the option to buy an outsized number of certain stocks and commodities and build controlling positions in those. Such imbalance in power disrupts the corporate voting block or commodities market and creates market volatility.
Determining the Limit
Commodity Futures Trading Commission determines the Position Limit on a net equivalent basis by contract. It means one options contract that controls 100 futures contracts is equivalent to 100 individual futures contracts. The owner of the former is viewed the same as the owner of the later. It is a way to measure the control of a trader on the market. Position limits are imposed on an intraday basis. That means a position limit is applicable throughout a trading day. If the limit is crossed by any trader at any given point of time during the trading day, it is considered as a violation. For instance, the Commodity Futures Trading Commission may specify that a trader or a group of traders is not allowed to hold more than 15 contracts on a specific stock in a day. So, 15 is the position limit imposed by the CFTC. No investing party is allowed to cross this limit at any point of time during the trading day. The Position Limit is in place to ensure fairness in the market. However, CFT may offer some exemptions from the imposed position limit in certain cases.