A derivative product is a financial product that derives its value from another, underlying financial product. For example, an option to buy a share is a financial product which derives its value from that underlying share. Similarly, an interest rate swap derives its value from the value of the cash flows on the underlying loan. Hence the term “derivative”.

Therefore, the two fundamental reasons why derivatives are used are earning income and managing risk. To achieve these goals, derivatives are use in speculation, hedging, asset liability management and arbitrage. In speculation, a derivative product may enable an investor to mimic the result of trading on an underlying financial market by entering into an off -market transaction with a financial institution. In hedging, derivative products can also be used as a risk management tool against market movements or rate changes. In asset liability management, a financial, or other, institution seeks to deal with its portfolio of liabilities, their size and exposure to market movements can be managed by the use of derivative instruments. In arbitrage, the use of derivative products makes it possible for market users to take advantage of mismatches in prices or market conditions by speculating on the underlying financial products without the need to undergo the formalities of conventional market trading.

What is Options?

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a security at a predetermined price on or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract. Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date. Put options give the taker the right but not the obligation to sell the underlying shares at a predetermined price on or before a predetermined date. The taker of a put is only required to deliver the underlying shares if they exercise the option. An option taker is an investor or trader anticipating a significant move in a particular share price. Taking an option offers the opportunity to earn a leveraged profit with a known and limited risk.

Why trade in Option?

1. Risk Management: Put options, when taken, allow you to hedge against a possible fall in the value of shares you hold.
2. Time to decide: By taking a call option, the purchase price for the shares is locked in. This gives the call option holder until the expiry day to decide whether or not to exercise the option and buy the shares. Likewise, the taker of a put option has time to decide whether or not to sell the shares.
3. Speculation: The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If you expect the market to rise, you may decide to buy call options. If you expect a fall, you may decide to buy put options. Either way you can sell the option prior to expiry to take a profit or limit a loss.
4. Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow you to benefit from a change in the price of the share without having to pay the full price of the share.
5. Diversification: Options can allow you to build a diversified portfolio for a lower initial outlay than purchasing shares directly.
6. Income generation: You can earn extra income over and above dividends by writing call options against your shares, including shares bought using a margin lending facility. By writing an option you receive the option premium up front.

Shariah Non-Compliance

The paper finds that options are prohibited for two principle reasons: Gharar and an invalid subject matter (mabi’) of sale. Options is prohibited because it is a form of bay’ al-Gharar. The option is Gharar. The exercising of the option is unknown and uncertain. The uncertainty in the subject matter makes it Gharar. It is a right which enforces another contract, however, the enforcing is uncertain and suspended on an uncertain event. Hence, it is different to other rights, this right is a right with Gharar.

In respect to options, the OIC Islamic Fiqh Academy states that:

“Option contracts as currently applied in the world financial markets are a new type of contracts which do not come under any one of the Shariah nominated contracts. Since the object of the contract is neither a sum of money nor a utility or a financial right which may be waived, then the contract is not permissible in Shariah.

Alternative solution

In presenting an alternative to options, Arbun is considered. The conclusion of a contract pertaining to ascertained assets is permitted according to the Shariah, along with the payment of part of the price as ’Arbun (Earnest Money) with the stipulation that the buyer has the right to revoke the contract within a specified period in lieu of the entitlement of the seller to the amount of earnest money in case the buyer exercises his right of revocation. It is not permitted to trade the right established with respect to the earnest money.

The paper notes that although Arbun, Khiyar, Hamish Jiddiyyah all give the holder a choice, however, they cannot be traded like options. If the objective is to give the holder a choice to complete a transaction or trade, these can be used. However, if the objective is to trade risk, such concepts in Islamic finance cannot be used to replicate options.

Wa’d has been used to create option structures engineered for risk management in currency exchange, although this is not universal, i.e., not all banks use these structures. The banks that do use these structures do so upon the approval of their Shariah Advisory Boards. One structure has been developed using Wa’d. A fee is paid, one through the mechanism of a commodity Murabahah and the other with direct payment of fees

In conclusion, options and futures contracts cannot be traded under Shariah, as they are too remote from the underlying assets, which is Gharar (contractual uncertainty) in essence.