What is meant by “Market Wide Position Limit” in derivatives ?

Question

what are the reason for setting up the “Market Wide Position Limit” for

derivatives?

Answer 1

<<<what is meant by “Market Wide Position Limit” in derivatives ?>>>

The total number of contracts one trader may have active at one time for a given underlying. For example, the limits for stock options

"vary according to the number of outstanding shares and past six-month trading volume of the underlying stock. The largest in capitalization and most frequently traded stocks have an option position limit of 250,000 contracts (with adjustments for splits, re-capitalizations, etc.) on the same side of the market; smaller capitalization stocks have position limits of 200,000, 75,000, 50,000 or 25,000 contracts (with adjustments for splits, re-capitalizations, etc.) on the same side of the market. The number of contracts on the same side of the market that may be exercised within any five consecutive business days is equal to the position limit. Equity option positions must be aggregated with equity LEAPS positions on the same underlying for position and exercise limit purposes. Exemptions may be available for certain qualified hedging strategies."

<<<what are the reason for setting up the “Market Wide Position Limit” for derivatives?>>>

I can think of two good reasons.

First, it limits risk. Huge option positions can create huge losses. If the trader is unable to cover the losses, his brokerage must. If the brokerage is unable to cover the loss, the Options Clearing Corporation must. To be sure the brokerages are almost always able to cover the loss, and the OCC can always cover any losses brokerages cannot, the maximum position sizes need to be limited.

Second, it prevents options positions from have too much influence on the price of the underlying. Options market makers frequently must trade the underlying to hedge their options positions. If the options positions get too large, those trades can have an impact on the price of the underlying. For example, assume a market maker is short 100,000 put options with a strke price of $100 on stock XYZ, all of which expire in two days. The market maker knows that if the stock is above $100 at expiration all of those options will expire worthless, but if the stock is below $100 at expiration he will have to buy a billion dollars worth of the stock (10 million shares for $100 each). So, if at the close of business on the Friday before expiration the market maker will either want to have no position in the stock (if it is over $100 per share) or be short 10,000,000 shares (if it is under $100 per share). If shortly before expiration there is some bad news ant the stock drops from $110 per share to $90 per share the market maker could suddenly find himself needing to sell 10,000,000 shares in a short time. That kind of selling would drive down the price of the stock.

That example is somewhat simplified to illustrate the principle. In reality it would probably be impossible for a market maker to have assumed that much unhedged risk.