Differences Between Bonds & Options

When most people think of investing, they tend to think of buying stocks on the stock markets. Buying stocks is certainly a common form of investing, but the financial markets also offer many other trading instruments that can be bought and sold to potentially return profits. With enough time devoted to research, learning about the various financial instruments that can be traded, and the strategies involved, it's definitely possible for anyone to become a competent investor.

In fact, with so many online brokers providing access to the financial markets it's easier than ever to get involved with investment, no matter what initial capital is involved and how much time an individual has.

However, many people are reluctant to do much more than simply invest in stocks and shares as that usually seems the most simple and straightforward way to invest. The fact that there are so many different forms of investment can seem bewildering, particularly to those with fairly limited experience, and it often makes more sense to just stick with buying stocks. This is understandable in many ways; the wide range of financial instruments in the market can be very confusing.

For example, bonds and options are both widely available from brokers and can both be used as part of an investment strategy, although they actually have very different characteristics. The fact that they are both a form of contract, though, can result in people mistakenly believing that they are the same thing.   A frequently asked question is “What are the differences between options and bonds?” On this page we answer that question by looking at the main differences and also some of the advantages that options trading has over buying bonds.

Main Differences

Options and bonds are both financial contracts between two parties, and it's this similarity that does sometimes lead to confusion. The simplest way to highlight the differences is to first provide a simplified definition of both of them.

The term bond is used to refer to a specific type of contract between a borrower and a lender. This contract requires the borrower to adhere to specific terms regarding repayment. The borrower is known as the issuer, and they issue a certificate to the lender who becomes the holder. The certificate can be sold on the market, and the new holder becomes the owner of the debt security.

Bonds are a type of fixed income security because the amount of interest payable on the loan is fixed in the contract. In addition, the issuer must repay the original amount borrowed in full when the bond expires. Bonds are traditionally issued by governments and large companies.

An options contract also consists of two parties. The buyer, or holder, of an options contract has the right (but not the obligation) to buy (a call) or sell (a put) a specific security at a fixed price. While the holder can choose whether or not to exercise their right, the seller, or writer, of the contract must meet their obligation if called upon to do so.

Options do not offer the holder a fixed return, and their value can fluctuate depending on price movements of the underlying security. They can expire worthless if there is no benefit in exercising the right to buy or sell the underlying security.

So options and bonds are actually very different in terms of the way they work. Bonds are basically an investment vehicle for a buy and hold strategy, given the fixed return they offer and the value they hold based on the pay out at expiry. However, options are trading instruments that can be used to watch out for the price movements of a wide range of underlying securities.

Although both of these options have a fixed expiration date, bonds offer the security of a pay out when they expire while options can expire worth nothing at all. Bonds also usually have very long lives, often running for 30 years or more. Options tend to have much shorter term contracts. Both investments have their places in an investment portfolio, but there are many more strategies for trading options and  there are some clear advantages too.

Advantages of Options Over Bonds

Bonds are a very safe form of investment as they are typically issued by governments or well established companies. This means there is very little risk of the holder not getting their regular returns or not getting principal sum returned at the point of expiry. However, the returns offered by bonds reflect this low risk, and you would be unlikely to ever make substantial profits unless investing very significant sums of money into them.

Options, on the other hand, offer the potential for big profits: often with very little starting capital required.  They can be bought and written based on a wide variety of underlying securities  including stocks, foreign currencies, and commodities.  They provide a huge range of opportunities for investment and speculation.

There are strategies for trading options that can be used regardless of whether there is a bull market, a bear market, or a neutral market.  Options can be traded under virtually any circumstance with a chance of making a return. Most strategies involve creating options spreads which can be used to create strong opportunities for profit while also keeping the risk to reward ratio at a level you feel comfortable with.

Options trading is certainly somewhat more complex than other forms of investing, but the rewards can definitely be worth it if you are prepared to put in the required effort. Once you understand the basics of the options market and feel comfortable that you know what is involved, then getting started is not as difficult as you might have thought.