What Is an Exercise Limit?

An exercise limit is a restriction on the number of option contracts of a single class that any one person or company can exercise within a fixed time period such as five business days. This limit is in place so that no one person or company can corner or greatly impact the options market or the market in the underlying security.

Along with position limits, these restrictions help keep markets fair and efficient.

Key Takeaways

  • An exercise limit caps the number of option contracts in a single class that an entity can exercise within a given time period.
  • Exercise limits, along with position limits, seek to limit market manipulation and/or other unethical practices.
  • Exercise limits and position limits both exist for a reason. It is possible to breach exercise limits without violating position limits.

Understanding the Exercise Limit

The purpose of option exercise limits and position limits is to prevent manipulation, such as corners and squeezes, in underlying securities markets, and to avoid disruptions in options markets which are illiquid

These limits prohibit an account, along with any other accounts controlled by the same entity, from cumulatively exercising in excess of a pre-determined number of options contracts associated with a particular underlying security. This includes situations involving early exercises and expiration exercises.

If the exercise limit was not in place, a trader could purchase enough call options and then exercise them to own enough of the underlying asset to control most of the underlying market. In stocks, this means that a bad actor could effect a takeover of a company and its controlling votes through the exercise of options alone. In commodities markets, it could allow a bad actor to corner the market and artificially inflate the price of products such as silver, crude oil, or soybeans. 

In the case of disrupting illiquid options markets, an exercise of a long option will always result in the assignment of a short options position. This means that many unsuspecting options writers will suddenly be placed in long or short positions in the underlying stock. As these traders try to exit or re-establish their prior positions, the prices of the options contracts, being illiquid, could swing wildly.

Position limits and exercise limits both attempt to cap how big of a position an entity has, but they are controlling different things. It is possible that an exercise limit is breached without a position limit being breached, since an exercise limit is cumulative over a five day period. A trader could stay below their position limit by buying contracts every day, exercising them, and then buying more contracts up to their position limit again. They aren't violating position limits, but they may violate exercise limits when all their exercised positions are tallied.

Real Example of Exercise Limits

Copper options on the Chicago Mercantile Exchange (CME) have a five-day exercise limit of 5,000 contracts, meaning no person or group can exercise more than 5,000 copper contracts over any five-day period.

The exchange for the options will provide a position and exercise limit table that traders can refer to.

For equity options on stocks, the exercise limit will often depend on the volume and liquidity of the underlying security, and can be changed pending review by an exchange and the Securities and Exchange Commission (SEC).