Before we go into whether options are Halal or Haram, let’s make sure we understand what options are.
Generally speaking, there are two types of options:
1. Call options
Are financial contracts that give holders the right, but not the obligation, to buy an asset at a certain price.
E.g. Company XYZ shares are trading for $100/share. A call option may give its holder the right to buy the company at 110$ a share for the next month.
This means the option will only hold intrinsic value if the price of XYZ shares rises to above $110/share.
If the price of the underlying stock remains below $110 for the next month, the option will expire worthless.
Why use a call option?
If you need to buy a particular asset in the future and you want to hedge the risk of the price going up during your buying window, a call option can limit this risk for you.
E.g. Let’s say you represent a multinational corporation and you know you’re going to need to buy 1 million barrels of oil over the next year.
Currently, the price of a barrel of oil is $50.
If the price goes above $60/barrel your company is in big trouble. So you want to hedge this risk.
To do this, you can buy a call option that allows you to buy oil for $60 a barrel anytime during the next year.
Speculating on price.
Another reason to buy a call option is to speculate on the price of the underlying asset.
E.g. Oil is currently trading for $50 per barrel.
I forecast Oil will trade above $60/barrel during the next year.
A call option that allows me to buy a barrel of oil anytime during the next year for $59/barrel trades for a price of $1 per contract.
If during the next year, my $60+/barrel forecast materializes, my call option will be worth more than the $1 I paid for it and I can sell my contract for a profit.
The higher the price of an Oil barrel becomes, the more valuable my call option become.
2. Put Options
Are financial contracts that give the holder the right, but not the obligation, to sell an asset at a certain price.
Why use a put option?
If you own a particular asset which you intend on selling and you want to hedge the risk of your asset’s price going down, a put option will allow you to do this.
E.g. You represent a multinational corporation and you know that you are going to sell 1,000,000 barrels of oil over the next year.
Currently the price of a barrel is $50.
If the price drops to below $40/barrel your company is in trouble.
To limit the risk of this happening, you can buy a put option that will allow you to sell your oil for $40/barrel even if the market price drops below $40.
Speculating on price.
Another reason to buy a put option is to speculate on the price of the underlying asset.
E.g. Oil is currently trading for $50 per barrel.
I forecast Oil will trade below $40/barrel during the next year.
A put option that allows me to sell a barrel of oil anytime during the next year for $41/barrel trades for a price of $1 per contract.
If during the next year, my sub $40/barrel forecast materializes, my put option will be worth more than the $1 I paid for it and I can sell my contract for a profit.
The lower the price of an Oil barrel becomes, the more valuable my put option becomes.
Are Options Halal or Haram?
I’ll tell you what I think and then you can make up your own mind.
Keep in mind I don’t represent anyone but myself so make sure you consider the opinions of multiple sources before you reach a conclusion.
Allah SWT prohibits something called Al Maysir.
In the generous Quran 5:90-91 , a translation of what Allah (SWT) says is:
“O you who believe, intoxicants, Al-Maysir, sacrificing for idols and making decisions based on games of chance are sicknesses from the work of Satan, so avoid these things so you may prosper. Satan desires to create enmity and hatred among you through intoxicants and Al-Maysir and to stop you from praying and remembering Allah. So will you abstain from these things?”The Holy Quran 5:90-91
As I pointed out in a previous video, Al-Maysir is defined as an activity where the following two conditions are met:
- Participants risk their wealth in hopes of material gain. i.e. They are creating risk.
- There are no prospects for creating anything useful from the activity.
A prime example of Al-Maysir is gambling in a casino.
When players gamble, they are risking their money in hopes of material gain (first condition) and their act of gambling carries no prospects of producing anything useful (second condition).
Can Options be Useful?
When options are used to hedge risk i.e. transfer a certain risk from its current bearer to another party more able to assume it, this is useful.
Suppose you are carrying a backpack full of rocks that is wearing on you.
Along comes someone with a stronger back who offers to carry your rock-filled backpack for a fee.
Can this person’s service be useful to you? certainly.
You get the rock-filled backpack off your back and the strong-backed person is able to monetize their strength by carrying your backpack.
When options contracts are used to hedge risk, the backpack full of rocks represents risk and the options contract represents the mechanism by which the rock-filled backpack is transferred from one person’s back to another person’s back who is more willing and able to carry the weight.
Are Options Always Useful?
When both sides of the options contracts are speculating on the price of the underlying, the option creates no usefulness for anyone.
In such a case, there is no risk being transferred.
There is no backpack full or rocks that is changing shoulders.
Rather, the option contract is merely a bet between two parties wherein one party’s gain is the other party’s loss. Consequently, the contract becomes devoid of usefulness.
In this case, both criteria for Al-Maysir are met:
- Both parties are risking wealth in hopes of material gain.
- There are no prospects for anything useful to come from this activity.
Therefore, if you are speculating on the price of an options contract and you don’t know for sure whether the counter-party in your contract is simply speculating on price too or hedging their risk, it is possible that you are engaged in Al-Maysir.
I would venture to guess that most options contracts available to retail traders are simply means of speculation and therefore fall in the Al-Maysir category.
Why is it haram to speculate on the price of options but not haram to speculate on the price of assets e.g. stocks?
Stocks are valuable in and of themselves.
When you purchase a stock, the risk of ownership is transferred from the previous owner to you.
There is no creation of risk that happens when stocks are traded.
On the other hand, options are considered derivatives. This is because they derive their value from the price of some other underlying asset.
When an option contract is written, the risk of owning this option contract didn’t exist previously. It was created out of thin air.
Consequently, with derivatives, there is no limit on how much risk can be created.
This is why Warren Buffett referred to derivatives as “financial weapons of mass destruction.”
Consider the following example…
Let’s say you want to speculate on the price of XYZ company by owning its stock.
XYZ has 10 shares outstanding.
The maximum number of XYZ shares you can buy is 10.
On the other hand, if you speculate on the price of XYZ using options, the maximum number of options you can buy is theoretically infinite.
This unchecked creation of risk using options contracts is what necessitates added restrictions on dealing with them.
How can I know if I’m speculating (haram use of options) or hedging my risk (halal use of options)?
Ask yourself the following question:
Would I still be interested in buying this option if I knew that any profits I earned would be taxed at a rate of %100?
In other words, would I still be interested in these options if there was no possibility for me to earn any profit from them?
To clarify even further, if the only course of action I had were to either exercise my option or let it expire worthless, would I still buy it?
If the answer is yes, then you are likely using options to hedge your risk and it is therefore halal.
If the answer is no, then there is an element of speculation in your dealings with options and it is therefore haram.
Those were my two cents on options trading anyway.
Let me know what you think in the comments section below.
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