Before we go into whether options are Halal or Haram, let’s make sure we understand what options are.
There are two types of options:
1. Call options
A call option is a financial contract that gives you the right, but not the obligation, to buy an asset at a certain price.
E.g. Company XYZ shares are trading for $100/share. A call option may give me the right to buy the company at 101$ a share for the next month.
This means the option will only be exercised if the price of the share rises to above $101. If the price of the underlying stock remains below $101 for the next month, the option will expire worthless.
Why use a call option?
Hedging risk. If you need to buy a particular asset in the future and you want to hedge the risk of the price going up in the future, a call option can eliminate 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 of a barrel of oil goes above $60 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 over the next year.
Speculating on price. Another reason why you might buy a call option is to speculate on the price of the asset.
E.g. if I think that oil is going to be above $60 a barrel, I can buy a call option and the higher the price of a barrel of oil gets, the more valuable my call option will become.
2. Put Options
A put option gives the holder the right, but not the obligation, to sell an asset at a certain price.
Why use a put option?
Hedging Risk. If you own a particular asset which you intend on selling and you want to hedge the risk of it’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 but if it drops to below $40 a barrel your company is in trouble. In this case, you can buy a put option that will allow you to sell your oil at $40 even if the market price drops below $40. So you’ve eliminated part of the price risk of selling oil.
Speculating on price. E.g. if I think that oil is going to fall below $40 a barrel, I can buy a put option which allows me to sell at $40 and the lower the price of a barrel of oil gets, the more valuable my put option will become.
Halal or Haram?
I’ll tell you what I think and then you can make up your own mind. I don’t represent anyone but myself so make sure you take the opinions of multiple sources before you reach a conclusion.
Allah SWT prohibits something called Al Maysir. In the generous Quran 5:90-91 , the translation of what SWT says is:
“O you who believe, intoxicants, 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 amongst you through intoxicants and 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, Maysir is defined as an activity where the following two conditions are met:
- Participants are risking wealth in hopes of material gain.i.e. They are creating risk.
- There are no prospects for creating any value from the activity.
A prime example of 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 beneficial for anyone (second condition).
Keep in mind, when I say “beneficial” I am referring to usefulness. Money is not useful in and of itself, rather, it is a means for transacting in that which is useful.
As mentioned earlier, options can either be used to hedge risk or to speculate on price.
When using options to hedge risk i.e. transfer a certain risk from the bearer of this risk to another party more able to assume this risk, this creates value.
Suppose you had a backpack full of rocks that was wearing on you and you were able to transfer your backpack to someone else with a stronger back that had no problem carrying your rock-filled backpack for a fee. This creates value.
You get the backpack full of rocks off of your back and the stronger individual 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 backpack full of rocks is transferred from your back to another person more willing and able to carry the weight.
So while condition 1 in identifying Maisir can certainly be said to be true whenever options are being traded, condition 2 which is that there are no prospects for creating any value cannot be said to be true when the options are being used to hedge risk.
However, when options are used to speculate on price, both conditions of Maisir are met and therefore it is prohibited in Islam (haram).
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.
Options fall in the family of financial instruments called derivatives because they derive their value from the price of some other underlying asset.
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 shares of XYZ that can be bought is 10 i.e. the number of XYZ shares outstanding.
However, if you would like to speculate on the price of XYZ shares using options, the maximum number of options that can be bought is infinite. You don’t have to own XYZ stock in order to speculate on its price using options.
You just have to own the options contract which can be written out of thin air.
The possibility for the unchecked creation of risk using options contracts is what necessitates added restrictions on dealing with them.
This is why Warren Buffett referred to derivatives as “financial weapons of mass destruction.”
The reason why it’s halal to speculate on the price of stocks and haram to speculate on the price of options is because when you buy a stock a transfer of risk is happening from the owner to you. Risk is not being created. However, with options that are used to speculate on price, a net creation of risk is happening that can’t be justified by any prospects of creating value.
Those were my two cents on options trading.
Let me know what you think in the comments section below.
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