What Is a Position Limit?
A position limit is a preset level of ownership established by the U.S. Commodity Futures Trading Commission (CFTC) that limits the number of derivative contracts a trader, or any affiliated group of traders and investors may own. The limits are put in place to keep anyone from using derivatives to exercise undue control on a market.
- Position limits are established to inhibit any investing entity from exerting undue control over a market.
- The limits are made with respect to total control of stocks, options and futures contracts.
- The main point is to avoid allowing anyone to manipulate prices to their own benefit while hurting others.
Understanding Position Limits
Position limits are ownership restrictions that most individual traders are never going to need to worry about breaching, but form an important purpose in the derivatives world. Most position limits are simply set too high for an individual trader to reach. However, individual traders should be grateful these limits are in place because they provide a level of stability in the financial markets by preventing large traders, or groups of traders and investors, from manipulating market prices using derivatives to corner the market.
For instance, by buying call options or futures contracts, large investors, or funds, can build controlling positions in certain stocks or commodities without having to buy actual assets themselves. If these positions are large enough, the exercise of them can change the balance of power in corporate voting blocks or commodities markets, creating increased volatility in those markets.
For example in 2010 a hedge fund called Armajaro Holdings purchased nearly a quarter-million tonnes of cocoa and caused a price move that was statistically uncharacteristic. Cocoa reached all time highs early in the year and futures contracts were in their highest state of backwardation ever recorded. Cocoa peaked in value early in 2011, but began declining from there. Six years later the fund lost money on its cocoa investments as the price of cocoa fell 34 percent in 2016 on its way to making its lowest prices in a decade. The episode demonstrated two points of observation: cornering attempts can create statistically unusual price swings, and the effort is notoriously difficult and rarely worth the effort.
How Position Limits are Determined
Position limits are determined on a net equivalent basis by contract. This means that a trader who owns one options contract that controls 100 futures contracts is viewed the same as a trader who owns 100 individual futures contracts. It's all about measuring the control a trader can exert over a market.
Position limits are applied on an intraday basis. While some financial rules apply to the number of holdings, or exposure, a trader has at the end of the trading day, position limits are applicable throughout the trading day. If at any time during the trading day, a trader surpasses the position limit, she will be in violation of the limit. Note that traders may also receive an exemption from an imposed position limit from the CFTC in some instances.
Another form of limiting influence on market prices is the change margin requirements. Increasing margin requirements may not hinder an individual investor or group of investors, but it will increase the capital reserves necessary 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 where changed. This effectively curtailed prices as they peaked at that point and have not rising near their highs since.