Definition of position limit


What is a position limit?

A position limit is a preset level of ownership set by exchanges or regulators that limits the number of shares or derivative contracts that a trader, or any affiliated group of traders and investors, can own.

Position limits are established to prevent anyone from using their ownership control, directly or through derivatives, to exercise unilateral control over a market and its prices.

Key takeaways

  • Position limits are established to prevent any entity from exercising undue control over a particular market.
  • The main objective is to avoid price manipulation for personal gain at the expense of others.
  • These limits are commonly set with respect to total control of the number of shares, options, and futures contracts.
  • The sizes of position limits vary from market to market.

Understanding position limits

Position limits are proprietary restrictions that most individual traders will never have to worry about breaching, yet they do constitute an important purpose in the world of derivatives.

Most position limits are simply set too high for an individual trader to reach. However, individual traders should be grateful that these limits are in place because they provide a level of stability in financial markets by preventing large traders, or groups of traders and investors, from manipulating market prices and using derivatives to hog the price. market.

For example, when buying call options or futures contracts, large investors or funds can create control positions in certain stocks or commodities without having to buy real assets themselves. If these positions are large enough, exercising them can shift the balance of power in corporate voting blocs or in commodity markets, creating greater volatility in those markets.

For example, in 2010, a hedge fund called Armajaro Holdings bought almost a quarter of a million tons of cocoa and caused a price movement that was not statistically characteristic. Cocoa hit all-time highs at the beginning of the year and futures contracts were in the highest state of backwardation ever recorded.

Cocoa peaked in value in early 2011, but started to decline from there. Six years later, the fund lost money on its cocoa investments as the price of cocoa fell 34% in 2016 on track to hit its lowest prices in a decade. The episode demonstrated two points of observation: Attempts to round a curve can create statistically unusual price swings, and the effort is notoriously difficult and rarely worth it.

How position limits are determined

Position limits are determined on an equivalent net basis per contract. This means that a trader who owns one options contract that controls 100 futures contracts is considered the same as a trader who owns 100 individual futures contracts. It is about measuring the control that a trader can exercise over a market.

Position limits apply intraday. While some financial rules apply to the number of positions or exposure a trader has at the end of the trading day, the position limits apply throughout the trading day. If at any time during the trading day a trader exceeds the position limit, he is violating the limit.

Special Considerations

Another form of limiting influence on market prices is the change in margin requirements. Increasing margin requirements may not hamper an individual investor or a group of investors, but it will increase the capital buffers required to hold the same number of positions, making it much more expensive to corner the market.

For example, in 2011 the margin requirements for gold and silver were changed, causing the prices of both precious metals to fall after strong rallies.

www.investopedia.com

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Mark Holland

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