If an investor obtains a significant number of option contracts, they gain access to a substantial amount of stock. For example, assume an investor takes this position:
1,000,000 long CART $30 calls
With each contract covering 100 shares, 1 million long calls provide the right to buy 100 million Instacart (ticker: CART) shares for a total of $3 billion! If the investor were to exercise every call, they would own roughly 36% of outstanding CART stock (there are approximately 277 million shares outstanding at the time of this writing).
The Options Clearing Corporation (OCC) and FINRA limit the number of contracts a single party or collective group can control. This prevents large investors from trading many option contracts to “sneakily” gain a significant position “overnight.” SEC-enforced regulations require investors make public disclosures when they attain 5% or more of an issuer’s publicly-traded common stock.
Every options class maintains a unique position limit. Many large-cap stocks are subject to position limits of 250,000, meaning no investor can obtain more than 250,000 contracts on the “same side of the market.” An option type is considered to be on the same side of the market if both have the same market sentiment (bullish or bearish). Long calls and short puts (the bullish options) are on one side of the market, while short calls and long puts (the bearish options) are on the other.
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, and the combined 105,000 contracts exceed the 100,000 contract limit.
Answer choices A and B go over 100,000, but both choices include a bullish and bearish option. Unless the option types are both bullish or bearish, the contract numbers are not combined. Therefore, answer choices A and B do not violate position limits.
Answer choice D contains two bullish option types, but the combined number of contracts is 95,000. Therefore, position limits are not violated.
Exemptions from position limit rules are provided to investors using options to hedging or covered positions. FINRA Rule 2360 specifically identifies the following strategies as exempt:
To be clear, options contracts involved in a hedging or covered strategy do not count when determining if position limits have been violated.
The OCC maintains the Large Options Position Reporting (LOPR) system to keep track of prominent options positions established across the market. This system allows regulators to keep track of investor actions, regardless of where their accounts are held. The position limits discussed above apply to investors across all accounts they control.
If the LOPR system didn’t exist, an investor could establish accounts at multiple broker-dealers, avoid exceeding limits in each account, but exceed limits overall. For example, assume ABC stock maintains a position limit of 100,000 contracts. An investor could establish 80,000 long calls at Broker-Dealer A, 80,000 long calls at Broker-Dealer B, and 80,000 long calls at Broker-Dealer C. Although they don’t exceed the limits at any one broker-dealer, the investor accumulated a total position of 240,000 contracts across the three firms (violating the limit). The LOPR system provides regulators with investor data to determine if such situations occur.
FINRA Rule 2360 requires member firms to report customer (individuals and groups acting in concert) option positions to LOPR when at least 200 contracts on the same side of the market are acquired. Batch* LOPR reports must be submitted by 9:00 p.m. CT the business day after a reportable transaction occurs. For example, assume a customer performs an opening purchase of 500 call option contracts on a Monday. The customer’s member firm must report the position to LOPR by Tuesday at 9:00 p.m. CT.
*Batch reports are large data files involving all customers with reportable positions.
Member firms must report any changes to positions as long as a customer (or group acting in customer) maintains 200 or more contracts. If the customer’s position declines below 200 contracts, one final report must be made to LOPR, but no further reports are required (until 200 contracts are exceeded again).
The data received via LOPR is disseminated to options exchanges (e.g., the Chicago Board Options Exchange) and self-regulatory organizations (e.g., FINRA) to ensure position limits are being properly enforced. Firms that allow their customers to exceed limits or fail to make proper LOPR reports are subject to fines and sanctions. For example, FINRA fined BofA Securities, Inc. $5 million in 2022 for failure to make proper LOPR reports in over 7 million instances.
A similar but different concept is exercise limits. For the same underlying reason (preventing investors from becoming “overnight” significant shareholders), options regulations also place limits on the number of options that can be exercised within a five business day (one calendar week) period.
Each options class maintains a unique exercise limit, which you do not need to know for the exam. In the real world, many stocks are subject to an exercise limit of 250,000, limiting investors from exercising more than 250,000 option contracts on the same side of the market (combining the bullish and bearish options, similar to 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, and the combined 11,000 contracts exceeds the 10,000 exercise limit. Both sets of exercises occurred within a five-business-day window, so exercise limits were exceeded.
Answer choices A and D both seem to exceed the exercise limit, but the option types are not on the same side of the market. Unless the option types are both bullish or bearish, the contract numbers are not combined. Therefore, answer choices A and D do not violate exercise limits.
Answer choice B contains two bullish option types and the combined contracts exceeds 10,000. However, the exercises occurred more than five business days apart. Therefore, position limits are not violated.
Position and exercise limits apply to individual investors, financial representatives investing with discretionary authority, and groups “acting in concert” (investing together).
Discretionary authority occurs when a financial representative obtains trading authorization from a client and places trades on their behalf. Best suited for investors who lack the knowledge and/or time to invest their own capital, discretionary accounts enable registered representatives to make investment decisions for their clients. Representatives acting in this capacity are subject to position and exercise limits for the portfolios they control.
Groups “act in concert” when they invest together for a combined goal. For example, spouses must combine their portfolios for position limit purposes as married couples are considered always “acting in concert.” Or, 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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