What Is an Exercise Limit?
The term exercise limit refers to a restriction placed 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 placed so that no one person or company can corner or greatly impact the options market or the market in the underlying security. These restrictions help keep markets fair and efficient. The limit often varies depending on the volume of the underlying asset.
- 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 seek to limit market manipulation and/or other unethical practices.
- Without exercise limits, traders could purchase enough call options and exercise them to own enough of the underlying asset to control most of the market.
- Traders and firms that violate exercise limits are disciplined by FINRA.
Understanding Exercise Limits
Exercise limits are established by the Financial Industry Regulatory Authority (FINRA). This is an independent agency that regulates registered brokers and broker-dealer organizations across the United States. Its primary goal is to protect investors and the public from corporate fraud. FINRA has five ways to ensure a fair marketplace by:
- enforcing regulations to prevent misconduct
- using technology to prevent fraud
- disciplining individuals and firms that violate the rules
- providing education and information to investors
- resolving disputes
FINRA puts option exercise limits in place in order to prevent any market manipulation, including corners and squeezes, in underlying securities markets, and to avoid disruptions in options markets that 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 exercise limits were not in place, traders could purchase enough call options, then exercise them to own enough of the underlying asset to control most of the underlying market. For instance, a bad actor in the stock market could cause the 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.
The exercise of a long option always results in the assignment of a short options position when disrupting illiquid options markets. 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.
"There are no restrictions on exercise for the last 10 trading days before expiry," according to the Nasdaq.
Exercise Limits vs. Position Limits
FINRA enforces position limits along with exercise limits on options contracts to ensure that markets remain fair for all parties involved. A position limit is a level of ownership that is predetermined by exchanges or regulators. It limits how many shares or contracts that traders or firms are able to own. Although both the exercise and position limits try to cap how big of a position an entity has, they each control 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. But 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. By doing this, they aren't violating position limits, but they may violate exercise limits when all their exercised positions are tallied.
Example of Exercise Limits
Options exchanges provide a position and exercise limit table to which traders can refer. For example, copper options on the Chicago Mercantile Exchange (CME) have a five-day exercise limit of 5,000 contracts. This means no person or group can exercise more than 5,000 copper contracts over any five-day period.
For equity options on stocks, the exercise limit often depends on the volume and liquidity of the underlying security. It can be changed pending review by the exchange and the Securities and Exchange Commission (SEC).