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​Islamic Derivatives – Option Pricing & Factors Affecting Premium


A. Option Premium (Price of Option)
  • Option premium = price paid to buy an option
  • Reflects:
    • Value of the right to buy or sell
  • Changes depending on:
    • Market conditions and key variables


B. Key Variables Affecting Option Price


1. Underlying Stock Price (S)
  • Call Option (Right to Buy):
    • If S increases → option price increases
    • Reason:
      • Buying at lower fixed price becomes more valuable
  • Put Option (Right to Sell):
    • If S increases → option price decreases
    • Reason:
      • Selling at fixed price becomes less attractive


2. Volatility (Price Fluctuation)
  • Call and Put Options:
    • If volatility increases → both option prices increase
  • Reason:
    • Greater price movement = higher chance of profit
    • Benefits both upward and downward positions


3. Time to Maturity
  • Call and Put Options:
    • More time → higher option price
  • Reason:
    • More time increases probability of favorable price movement


4. Strike Price (K)
  • Call Option:
    • If K increases → option price decreases
    • Reason:
      • Buying at a higher price is less attractive
  • Put Option:
    • If K increases → option price increases
    • Reason:
      • Selling at a higher price is more valuable


5. Interest Rates
  • Call Option:
    • If interest rates increase → option price increases
  • Put Option:
    • If interest rates increase → option price decreases
  • Reason:
    • Higher rates reduce present value of future payments
    • Makes call options relatively more attractive


C. Overall Pricing Logic
  • Option price (premium) depends on:
    • Relationship between S (market price) and K (strike price)
    • Time available
    • Market uncertainty (volatility)
    • Economic conditions (interest rates)


D. Simple Summary
Call Option Price Increases When:
  • Stock price (S) ↑
  • Volatility ↑
  • Time ↑
  • Interest rates ↑
  • Strike price (K) ↓


Put Option Price Increases When:
  • Stock price (S) ↓
  • Volatility ↑
  • Time ↑
  • Interest rates ↓
  • Strike price (K) ↑


E. Key Insight
  • Option pricing is based on:
    • Probability of profit
  • Any factor that:
    • Increases chance of gain → raises option price
    • Reduces chance → lowers option price


F. Shari’ah Reflection
  • Despite pricing logic, options raise concerns:
    • Gharar
    • Maisir


Final Takeaway
  • Option premium is not fixed
  • It changes based on:
    • Market price, time, volatility, strike price, and interest rates
  • Understanding these factors is key to:
    • Valuing and using options effectively

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