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Position Limit Definition
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.
A Little More on What is Position Limit
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.
References for Position Limit
Academic Research on Position Limit
Position limit for the CSI 300 stock index futures market, Wei, L., Zhang, W., Xiong, X., & Shi, L. (2015). Economic Systems, 39(3), 369-389. This study attempts to find the optimal position limit for the Chinese stock index (CSI) 300 futures market. In order to find that optimal point this study proposes an artificial limit order market with heterogeneous interacting agents. It examines how different levels of position limits affect market quality. The realistic situation observed in the CSI 300 futures market is taken into account in developing the simulation model. The study finds based on the liquidity status in September 2010 in CSI 300, the optimal position limit to be 300. It shows increasing the position limit from 100 to 300 is beneficial for the Chinese financial system. However, increasing it further may not bring such a significant improvement in market quality. The study concludes increasing the position limit to a moderate level can bring significant improvement in the functionality of the CSI 300 futures market.
Arbitrage in stock index futures, Brennan, M. J., & Schwartz, E. S. (1990). The Journal of Business, 63(1), S7-S31. This article analyzes the Standard and Poor’s (S&P) 500 Stock Index Futures contract to determine optimal arbitrage strategies with transaction cost when the positions limits restrict the arbitrage potential.
Optimal arbitrage strategies on stock index futures under position limits, Dai, M., Zhong, Y., & Kwok, Y. K. (2011). Journal of Futures markets, 31(4), 394-406. The optimal arbitrage strategies in the stock index with transaction cost and position limits are examined. In this analysis, it is assumed that the index analysis will follow the Brownian Bridge process. The study particularly examines how the index arbitrage strategies are affected by the transaction cost.
Troubled futures? The global food crisis and the politics of agricultural derivatives regulation, Clapp, J., & Helleiner, E. (2012). Review of International Political Economy, 19(2), 181-207. The global food crisis of 2007-08 triggered a worldwide debate over the rapidly increasing financial investment in the agricultural derivative market in the recent past. This debate is discussed at the beginning of the paper. Then it discusses how the deregulation and market development has led to this situation and how it indicates towards financialization of food and agriculture. Then it discusses the US-led initiative to tighten regulations over agricultural derivatives markets during the food crisis. It attempts to analyze the domestic sources that led the US to take such an initiative. In its conclusion, the paper summarizes the broader theoretical significance of the analysis.
The role of economic analysis in futures market regulation, Peck, A. E. (1980). American Journal of Agricultural Economics, 62(5), 1037-1043. This paper discusses how economic analysis affects future market regulation. It presents an assessment of the speculative character of selective markets and highlights the impact of changes hedging requirements upon the speculative component in recent years.
Position limits for cash‐settled derivative contracts, Dutt, H. R., & Harris, L. E. (2005). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 25(10), 945-965. This article presents a model that is useful for determining the positions limits based on microstructure theory. The position limits suggested by the model is compared to the existing position limits, and it is found that these two are largely inconsistent.
CFTC examines position limits, Acworth, W. (2009). The Magazine of the Futures Industry, 19, 24-6. This article reports the hearings held by the Commodity Futures Trading Commission on the effectiveness of position limits in restricting excessive speculation in the commodity futures market. Representatives of industrial energy consumers, airlines, utilities, financial institutions, fund managers, members of Congress, academics and trade association participated in these three-day long hearings and expressed their views on the topic.
The effects of regulations on trading activity and return volatility in futures markets, Pliska, S. R., & Shalen, C. T. (1991). Journal of Futures Markets, 11(2), 135-151. This paper analyses how the regulations affect the trading activity and return volatility in futures markets.
The impact of index and swap funds on commodity futures markets, Irwin, S. H., & Sanders, D. R. (2010). This study analyses the role of index and swap fund participation in agricultural and energy commodity futures markets and suggests the bubble in agricultural futures prices are not a result of index funds. The study uses Granger causality method to analyze the relationship between changes in index and swap fund positions and increased market volatility and finds no significant connection. The evidence is stronger for agricultural futures markets as the data is more dependable than the data of energy commodity features market.
The “necessity” of new position limits in agricultural futures markets: The verdict from daily firm-level position data, Sanders, D. R., & Irwin, S. H. (2015). Applied Economic Perspectives and Policy, 38(2), 292-317. This paper analyzes the firm-level position data from across 13 US agricultural futures markets to find whether there is a necessity to introduce new position limits on speculation in the agricultural futures market. The results of the empirical analysis fail to establish any connection between the firm’s trading and market returns. It finds that the firm’s roll transactions are negatively related to the changes in calendar price spreads. The paper concludes that there is no need for new limits on speculation in the agricultural futures market.
Fundamentals of commodity options on futures, Wolf, A. (1982). Journal of Futures Markets, 2(4), 391-408. This article discusses commodity options on futures with a special focus on option pricing formula in Black (1976). It examines that formula and shows the method of calculating the theoretical values of options on futures. The paper says these values can be used as benchmarks for evaluating the premiums of options on futures.
Regulations and price discovery: oil spot and futures markets, Goyal, A., & Tripathi, S. (2012). Indira Gandhi Institute of Development Research, 2012-016. This paper compares the impacts of expected net demand and liquidity with that of leverage driven expansion on net long positions in the oil market. Time series tests for mutual and across exchange causality is applied in this analysis. Data from two international and one Indian commodity exchange is used. Short duration bubbles were also searched in the analysis. The study finds the Indian regulations like position limits may have been successful in mitigating the short duration bubbles. It suggests the excess volatility in oil price may be a result of the leverage due to lax regulation. It recommends well-designed regulations for improving market functioning.