Sometimes referred to as a trading limit, a position limit is a specific level or position that is created by a regulatory agency and associated with a particular investment contract or option. The purpose of a position limit is to prevent an influx of options that could threaten the stability of a market and create widespread difficulties for investors. Various options and futures contracts will carry a different position limit, based on the nature of the investment and the criteria set by the regulator.
In actual practice, a position limit serves to prevent any position associated with a given option from exceeding a proscribed maximum size. Doing so helps to minimize the potential for any one investor or group of investors from cornering a market and essentially undermining its stability. This does not mean that the position limit prevents anyone from earning a return on their investments. What it does mean is that a large trader does not gain an unfair advantage over smaller traders, and is less likely to be in a position to engage in market manipulation that threatens to undermine the entire marketplace.
The actual size that is allowed with the position will depend on a number of factors, including whether the entity holding the position is an individual investor, a group of investors, or a corporation. The number of shares involved with the contract will also often play some role in setting the maximum limit of shares associated with the option that a given entity may hold. Various other criteria may also apply, depending on the particulars of a specific futures contract.
In the United States, the tasks of determining this maximum number as it relates to futures contracts falls under the auspices of the Commodity Futures Trading Commission, or CFTC. Decisions are often made in conjunction with various exchanges that are based in the country. In other nations, it is not unusual for domestic regulatory agencies to also set a position limit that is independent of the criteria set by exchanges based in those countries, even though the exchanges normally conform their standards to match those of the government regulator.
In situations where an investor holds several contracts for the same investment with different brokers, those contracts are usually considered as if they were all under one contract. This creates a situation where it is still possible to impose the position limit equitably, and minimize the potential for any one investor gaining an unfair advantage over others who are also interested in that investment opportunity. Failure to observe a position limit by taking steps to circumvent the checks and balances inherent in the system can lead to fines or possibly a loss of investing privileges with one or more exchanges.