By Glenn M. Stewart

In the current international financial markets, a great deal of attention has been given to financial derivative products. What are derivatives?
Broadly speaking, they are financial instruments which have been created or derived from another financial product or contract. As a result, one can create new financial rights and obligations out of existing ones.
Derivatives can be built from bonds, stocks, foreign currencies, or even stock indices. In most cases one of the essential elements of a financial derivative is the existence of some sort of option contract.
I wish to examine the legal framework that exists within Islam as derived from the ahadith literature and from fiqh and consider its implications for the development, purchase and sale of these instruments within the ambit of what is permitted and forbidden in Islam as it pertains to financial transactions.
Clearly, any derivative instrument that is based upon riba either in the underlying instrument or in the derivative instrument would be forbidden. The Islamic prohibition of riba is absolutely explicit in both theQuran and Sunnah and needs no further elaboration. As a result option contracts on interest bearing debt securities, for example, would clearly not be permissible under the Sharia.

What then of a financial product that does not contain an obvious element of riba. In this case I believe that we need to first examine the option contract itself in light of the Sunnah.
What is an option?
According to a booklet published jointly by the American Stock Exchange, the Chicago Board Options Exchange Inc. and the New York, Pacific & Philadelphia Stock Exchanges:
An option is the right to buy or to sell a specified amount or value of
a particular underlying interest at a fixed exercise price by exercising
the option before its specified expiration date. An option which gives
a right to buy is a call option, and an option which gives a right to sell
is a put option. 1
Since this booklet very clearly defines a number of key terms and concepts which are relevant to this examination, I also wish to quote the following therefrom:
There are two different kinds of options “ physical delivery options and cash-settled options. A physical delivery option gives its owner the right to receive physical delivery (if it is a call), or to make physical delivery (if it is a put), of the underlying interest when the option is exercised. A cash-settled option gives its owner the right to receive a cash payment based on the difference between a determined value
of the underlying interest at the time the option is exercised and the fixed exercise price of the option. A cash-settled call conveys the right to receive a cash payment if the determined value of the underlying interest at exercise “ this value is known as the exercise settlement
value  exceeds the exercise price of the option, and a cash-settled
put conveys the right to receive a cash payment if the exercise settlement value is less than the exercise price of the option.
Each options market selects the underlying interests on which options are traded on that market. Options are currently available covering four types of underlying interests: equity securities, stock indexes, government debt securities, and foreign currencies. Options on other types of underlying interests may become available in the future. 2
The first case that I would like to examine is that of cash-settled options. As we have already seen:
A cash-settled option gives its owner the right to receive a cash payment based on the difference between a determined value of the underlying interest at the time the option is exercised and the fixed exercise price of the option. 3
Thus all cash-settled options would involve the exchange of two monetary assets.
In the case of any monetary transactions where both counterparties to the transaction are exchanging a monetary asset, one should refer to the following hadith:
Malik b. Aus b. Al-Hadathan reported: I came saying who was prepared to exchange dirhams (for my gold), whereupon Talah b. Ubaidullah (Allah be pleased with him) (as he was sitting with Umar b. Khattab) said: show us your gold and then come to us (at a later time). When our servant would come we would give you your silver (dirhams due to you). Thereupon  Umar b. Khattab (Allah be pleased with him) said:
Not at all, By Allah, either give him his silver (coins), or return his gold to him, for Allah’s messenger (may peace be upon him) said: Exchange of silver for gold (has an element of) riba in it, except when (it is exchanged) on the spot; and wheat for wheat is riba unless both are handed over on the spot; dates for dates is riba unless both are handed over the spot
( ‘ila ha’a wa ha’a). 4
Secondly, any exchange of monetary assets must be like for like and equal for equal. If on the exercise date, the option price was either below or above the market price a cash-settled option would entail the exchange of two monetary assets at different countervalues and would thus entail an element of riba Alfadl for one party or the other.
This is further elaborated in the following hadith:
Abu Sa’d al- Khudri reported Allah’s messenger (may peace be upon him) as saying: Do not sell gold for gold, except like for like, and do not increase something of it upon something; and don’t sell silver unless like for like, and don’t increase something of it upon something, and do not sell for readymoney something to be given later. 5
As a result it would appear that any option contract in respect of the exchange of monetary assets should be scrutinized in reference to these two hadith particularly if the option is either in the money or out of the money i.e. if the current market value of the underlying interest is above or below the exercise price of the option.
Also of importance in examining option contracts in reference to the Sunnah are the questions concerning the existence of the underlying interest on which the option contract is written and the premium itself.
In the case of a physical delivery option, it must be determined whether the option writer is covered or uncovered.
If the writer of a physical delivery call option owns or acquires the amount
Of the underlying interest that is deliverable upon exercise of the call, he
Is said to be a covered call writer. 6
Let us look at the premium itself. The Chicago Board Options Exchange publication gives us this definition.
The premium is the price that the holder of the option pays and the writer of an option receives for the rights conveyed by the option. It is the price set by the holder and writer, or their brokers, in a transaction in an options market where the option is traded. It is not a standardized term of the option. The premium does not constitute a down-payment.
It is simply and entirely a nonrefundable payment in ”from the
Option holder to the option writer “ for the rights conveyed by the option. 7
It also makes the following relevant point concerning the Expiration Date if an option expires.
If an option has not been exercised prior to its expiration, it ceases to exist, that is, the option holder no longer has any rights, and the option no longer has any value. 8
In respect of these points the following hadith is of relevance.
‘Amr b. Shu’aib reported on the authority of his father, who narrated on the authority of his father: The Messenger of Allah (may peace be upon him) said: The sale transaction of something which is not in your possession is not lawful, nor is the profit arising from something which does not involve liability.9
As a result it would appear that uncovered options do not meet the criteria laid down in this Hadith. This hadith would also apply to options written on stock indices where the underlying interest is an intangible good nor is it something owned by the option writer. It is in fact unownable. It would also appear to apply to the premium itself inasmuch as the option itself becomes valueless if it is not exercised. As a result, one party to the transaction has delivered a monetary asset to the other who has neither incurred a liability or exchanged an equal countervalue.
Let us now look at the whole issue of traded options in the light of the Sharia.
A traded option is an option which is detached from the underlying option contract and traded as an instrument in its own right and is quoted in the traded options market. Thus distinct from the underlying interest, a separate financial instrument has been created and can be bought and sold in various quoted markets. The ability to trade these options is, of course, the essence of the derivatives market.
In this case, the relevant hadith is one to which reference usually has been made in respect of those transactions which are deemed to be a’na or hila. However, it is also relevant to traded options;
Abu Huraira (Allah be pleased with him) reported that the messenger of Allah (may peace be upon him) said: “If a person conducts two transactions contained in one, he should stick to the lower one or he will commit an act (involving) riba. 10
Thus it would appear that the detaching of the option contract itself from the underlying interest which is itself a contract to deliver the underlying interest upon the exercise of the option within the option period must be examined in the light of this hadith.
If it is felt that references to the original ahadith need to be clarified, an examination of Abd Al Rahman Al Jaziri’s book Al Fiqh ‘ala Al Madhahib Al-Arba’ah will provide one with a useful summation of the legal opinions concerning Riba of all four leading schools of Islamic Jurisprudence.
Indeed even the Ja’afari school is in full agreement in this area and their jurists agree on the complete prohibition of riba. One can refer to a book such as Tadhakirah Al Fuqaha by Hasan ibn Al Mutahhar if necessary.
In the case of all option contracts, it is important to examine them not only in the light of the prohibition on riba but also in respect of any element of gharar which might exist.
Much of the fiqh scholarship concerning gharar is derived from the following a hadith:
Abu Huraira reported it directly from Allah’s Apostle (may peace be upon him): The townsman should not sell for a man from the desert (with a view to taking advantage of the ignorance of the market conditions of the city). And Zuhair reported from the Holy Prophet (may peace be upon him) that he forbade the townsman to sell on Behalf of the man from the desert.
Anas b. Malik reported: We were forbidden that a townsman should sell for a man of the desert, even if he is his brother or father. 11
These ahadith convey the specific prohibition of selling to someone who is ignorant of the market. In addition, they have also established a general rule that means that all transactions should not contain uncertainty or be speculative in nature.
Unfortunately, few of the early Muslim fuqaha have properly defined gharar. The jurist Ibn Qayyim Al-jawziyya wrote about gharar in his book I’lam Al-Muwaqqin. But the primary thrust of his concern was with non-existence (adam) as being the overriding concern which established the prohibition of gharar.
The jurist Al-Qarafi also dealt with the subject of gharar in his book Al-Furuq but he was primarily concerned with the contracts wherein there was an element of majhul i.e. something unknown.
The jurist Sanhuri in Masdar Al Haqq also examined gharar, but looked at it primarily from the aspect of how a want of knowledge (jahl) creates an element of gharar.
Two Maliki jurists Ibn Rushd and Ibn Juzayy attempted to define gharar and the latter categorized it into ten cases.
In a recently published book Unlawful Gain and Legitimate Profit In Islam, Nabil Saleh who teaches Islamic Law at the School of Oriental and African Studies in London has attempted to summarize the rules concerning the prohibition of gharar as follows:
a) There should be no want of knowledge (jahl) regarding the
existence of the exchanged countervalues.
b) There should be no want of knowledge (jahl) regarding the
characteristics of the exchanged countervalues or the
identification of their species or knowledge of their quantities
or of the date of future performance, if any.
c) Control of the parties over the exchanged countervalues
should be effective. 12
He also makes the point that many modern scholars have looked at gharar primarily from the aspect of non-existence (adam) of the subject matter but we should keep in mind that gharar is a far more complex issue than this.
Once again, I would like to quote from the booklet published by the Chicago Board Options Exchange Inc.
An option holder runs the risk of losing the entire amount paid for the option in a relatively short period of time. This risk reflects the nature of an option as a wasting asset which becomes worthless when it expires. An option holder who neither sells his option in the secondary market nor exercises it prior to its expiration will necessarily lose his entire investment in the option. The fact that options become valueless upon expiration means that an option holder must not only be right about the direction of an anticipated price change in the underlying interest, but he must also
be right about when the price change will occur. If the price of the underlying interest does not change in the anticipated direction before the option expires to an extent sufficient to cover the cost of the option, the investor may lose all or a significant part of his investment in the option. This contrasts with an investor who purchases the underlying interest directly and may continue to hold his investment, notwithstanding its failure to change in price as anticipated, in the hope of waiting out an adverse price move and eventually realizing a
profit. The significance of this risk to an option holder depends in large part upon the extent to which he utilizes the leverage of options to control a larger quantity of the underlying interest than he could have purchased directly with the same amount. 13
Thus it would appear that all aspects of gharar are potentially present in any option contract. There could be a want of knowledge regarding the existence of the exchanged countervalues. There could very easily be a want of knowledge regarding the characteristics of the exchanged countervalues or the identification of their species or knowledge of their quantities in the case of foreign currency options.
There could be a potential want of knowledge of the date of future performance in respect of all options.In the case of uncovered options control of the parties over the exchanged countervalues may not be present.
Finally, in the case of stock options, I would like to examine whether such contracts could be entered into through a mechanism known as bae al- arboon. First, it should be noted that bae al- arboon is accepted only by the Hanbali School and not by the other three main madhahib. In a bae al- arboon transaction, one party advances a portion of the purchase price for an asset and the seller gives the purchaser an option to buy the property within a set time period. If the buyer chooses not to complete the purchase, the seller may keep the amount that had been advanced and is not obliged to return it to the prospective buyer. However, if the buyer then goes on to complete the purchase, he pays the remainder of the purchase price and the amount originally advanced is treated as if it had been a downpayment.
It is important to bear in mind that traditionally bae al- arboon only applies to a sale of tangible goods and customarily has been applied mainly to transactions in land.
However, as we have seen, the Chicago Board Options Exchange Inc. publication has very clearly defined what an option premium represents. It is not a down payment and the full contracted price must be paid for the underlying interest on the exercise date.
Therefore, it would appear that bae al-arboon does not constitute a type of option contract along the lines of those we have been examining.
Finally I would like to say that the purpose of this paper has been merely to highlight what I believe to be certain issues concerning option and derivative contracts in the light of the Sunnah. Clearly, further study of these matters needs to be carried out. Since financial derivatives are an increasingly important segment of the international markets it is hoped that qualified fuqaha from the community will take the time to examine these contracts in more detail.
1. Characteristics and Risks of Standardized Options, American Stock Exchange, Incorporated, New York Stock Exchange, Inc. Pacific Stock Exchange, Incorporated and Philadelphia Stock Exchange, Inc. 1994
2. Ibid
3. Ibid
4. Khan, Mohammed Akram; economic teachings of Prophet Muhammad ( may peace be upon him), A Select Anthology of Hadith Literature on Economics; International Institute of Islamic economics and Institute of policy studies, Islamabad, 1989
5. Ibid
6. Characteristics and Risks of Standardized Options, Op. Cit.
7. Ibid
8. Ibid
9. Khan, Mohammed Akram, Op. Cit.
10. Ibid
11. Ibid
12. Saleh, Nabil; Unlawful Gain and Legitimate Profit in Islamic Law; Graham & Trotman, London 1992
13. Characteristics and Risks of Standardized Options Op. Cit.

Glenn StewartGlenn M. Stewart is a renowned expert on Middle Eastern affairs and business. a graduate of Oxford University, Glenn M.Stewart holds an advanced degree in Islamic History and Arabic and lived in the Middle East for 27 years. A successful entrepreneur and businessman, Stewart has a unique insight into this critical and important area of the world.

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