If an investor buys a large number of option contracts, they can control the right to buy or sell a very large number of shares. For example, suppose an investor takes this position:
1,000,000 long CART $30 calls
Each contract covers 100 shares, so 1,000,000 long calls give the right to buy 100,000,000 Instacart (ticker: CART) shares at $30 per share. That’s a total purchase price of $3 billion if every call is exercised.
If the investor exercised every call, they would own roughly 36% of CART’s outstanding shares (there are approximately 277 million shares outstanding at the time of this writing).
To prevent investors from using options to quickly build a large stock position, the Options Clearing Corporation (OCC) and FINRA limit how many contracts a single party (or a group acting together) can control. This helps prevent large investors from using options to gain a significant position “overnight.”
Separately, SEC-enforced rules require public disclosure when an investor reaches 5% or more of an issuer’s publicly traded common stock.
Every options class has its own position limit. For example, some options classes have a position limit of 250,000 contracts. This means no investor may hold more than 250,000 contracts on the same side of the market.
“Same side of the market” means the positions have the same market outlook:
Let’s take a look at a practice question:
ABC stock maintains an options position limit of 100,000 contracts. Which of the following portfolios violate the position limit rule?
A) 50,000 long calls and 55,000 short calls
B) 50,000 long calls and 55,000 long puts
C) 50,000 long calls and 55,000 short puts
D) 50,000 long calls and 45,000 short puts
Answer = C) 50,000 long calls and 55,000 short puts
Long calls and short puts are both bullish, so you combine them. The total is 105,000 contracts, which exceeds the 100,000-contract limit.
Answer choices A and B each total more than 100,000 contracts, but each includes one bullish position and one bearish position. Because they are not on the same side of the market, the contract counts are not combined. Therefore, A and B do not violate position limits.
Answer choice D includes two bullish positions, so you combine them. The total is 95,000 contracts, which is below the 100,000-contract limit. Therefore, D does not violate position limits.
Exercise limits are related to position limits, but they measure something different. Instead of limiting how many contracts you can hold, exercise limits restrict how many contracts can be exercised (or assigned) within a five-business-day period (about one calendar week). The goal is the same: preventing investors from becoming significant shareholders “overnight.”
Each options class has its own exercise limit, and you don’t need to memorize specific numbers for the exam. In practice, many stocks have an exercise limit of 250,000 contracts. This would limit an investor to exercising no more than 250,000 contracts on the same side of the market within the five-business-day window (combining bullish positions together and bearish positions together, just like position limits).
Let’s look at a practice question:
ZZZ stock maintains an exercise limit of 10,000 contracts. Assuming the contracts below were exercised or assigned within the same calendar year in an individual’s account, which set violates exercise limit rules?
A) 6,000 long calls on January 5th and 5,000 long puts on January 7th
B) 6,000 long calls on January 5th and 5,000 short puts on January 20th
C) 6,000 long puts on January 5th and 5,000 short calls on January 8th
D) 6,000 long puts on January 5th and 5,000 short puts on January 7th
Answer = C) 6,000 long puts on January 5th and 5,000 short calls on January 8th
Long puts and short calls are both bearish, so you combine them. The total is 11,000 contracts, which exceeds the 10,000-contract exercise limit.
The two exercises also occur within a five-business-day window (January 5th to January 8th), so the exercise limit is violated.
Answer choices A and D may look like they exceed 10,000, but each combines one bullish position and one bearish position. Because they are not on the same side of the market, the contract counts are not combined. Therefore, A and D do not violate exercise limits.
Answer choice B includes two bullish positions, and the combined total exceeds 10,000. However, the exercises occur more than five business days apart. Therefore, exercise limits are not violated.
Position and exercise limits apply to:
Discretionary authority means a financial representative has trading authorization from a client and can place trades on the client’s behalf. This is often used by investors who don’t have the time and/or knowledge to manage their own investments. Representatives with discretionary authority are subject to position and exercise limits for the accounts they control.
Groups “act in concert” when they invest together toward a shared goal. For example, spouses must combine their portfolios for position-limit purposes because married couples are considered to be acting in concert. Similarly, a joint account with multiple owners placing trades together is considered acting in concert. These groups are also subject to position and exercise limits.
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