A bond option allows the contract holder to buy or sell an underlying investment (in this case, a bond) at a specific price and at a specific time. While considered less risky than stock options, bond options still typically carry higher risk than more traditional investments.
Like all options, bond options are derivative securities, used by investors to bet on the direction of an underlying security. Understanding what bond options are and how they work can help you understand these risks and determine whether bond options make sense for your portfolio.
Here’s a closer look at bond options, and the risks and rewards they bring to investors.
What are Bond Options?
A bond option is a legal contract to buy and sell underlying bond assets, usually via a call bond (i.e., the option to buy an underlying bond) or a put bond (the option to sell a bond) at a specific price (known as the “strike price)” at or before a specific time deadline (known as the “expiration date”).
For example, an investor might purchase a bond call option with a strike price of $900. The level value (also known as “par value”) of the underlying U.S. government bond is $1,000. Let’s say market conditions push the value of that bond up to $1,100. In that scenario, the option holder has the right to buy the government bond at $900 – even as the value of that underlying bond now stands at $1,100.
Investors typically trade options, including bond options, through over-the-counter exchanges. Bond options are also typically available wherever U.S. Treasury bonds are sold in fund form through investment companies.
Recommended: A Beginner’s Guide to Options Trading
Pros and Cons of Bond Options
There are benefits and drawbacks to incorporating bond options in your portfolio.
Pros of Bond Options
Higher return potential. As discussed in the example above, when executed well a bond options strategy can increase a trader’s gains on a particular investment. Bond options can also protect against downside risk. Investors often use bond options as hedges against more risk-laden investment strategies.
Risk hedging. Bond options investors can leverage derivative contracts to take advantage of interest rates and other short-term drives of investment performance. Investors can also lean on bond options to take advantage of pricing variations in options pricing or to position their portfolios ahead of major geopolitical events, like presidential elections, potentially big Federal Reserve policy decisions, or major recessions and other powerful economic forces.
Cons of Bond Options
The risk of non-exercise. Bond options investors may do well to let an options contract expire rather than execute a trade that goes awry and loses money. While a bond options investor isn’t obligated to exercise their bond options contracts, letting a contract expire means the original money used to buy or sell a bond option is gone forever. So, too, are the fees investment companies charge to handle options trades.
The risk of unlimited investment loss. While call options provide an investor with the possibility of unlimited gain if the underlying security rises in value, that same investor faces unlimited loss potential if that investor is selling a call or put option. If the underlying assets plummet to a value of zero, the options investor could face massive financial losses.
The risk of losing money quickly. As options, by nature, are short-term investing instruments, investors need to have extensive knowledge of near-term investment price movements to minimize the downside risk of investing in bond options. Often, traders make decisions about their options strategy based on a short time horizon. That means all options investors must master two key trading objectives – knowing the right time to purchase an options contract and knowing when to sell that contract, or cut losses by allowing the contract to expire without exercising the option to buy or sell by the expiration date.
Recommended: 10 Options Trading Strategies
Types of Bond Options
Bond options offer investors the right to buy or sell (via calls and puts) an underlying investment security at a specific time and at a set price.
Call Option Bonds
With a bond call option, if the price of the underlying bond option rises in value, the contract holder can earn a profit on the call by exercising the option to purchase the asset (with a call option) at a lower price and then selling it when the underlying asset goes up. A call option is in the money if the strike price is lower than the current market price of the underlying bond.
Bond Put Options
A bond options investor who buys believes a bond will go up in price may purchase a put option or put bond. With that option, buy the asset at the current low price and sell it at the rising strike price, assuming the price moves in the direction the trader had hoped. What a bond investor strives to avoid is being on the wrong side of an options trade, i.e., selling at a below market rate or buying at an above-market rate.
If an investor anticipates that bond prices will decline, given future expected market conditions, they’d purchase a put option. If the level value of the underlying bond option were$1,000, a bond put option gives the contract holder the right to sell the option contract at the strike price of $900 – on or before the expiration date. If bond prices fall, the underlying bond is now valued at $870. Now, that bond option investor can exercise the sale of the options contract at the strike price of $900, even as the bond’s value has fallen to $870. That guarantees a big profit for the investor, given the outsized nature of options contracts.
Embedded Bond Options
Embedded bond options are bonds in which the holder or the issuer has a right to take a specific action with a certain period going forward. Examples of embedded bond options include call provision, convertible provisions, and floored floating-rate provisions.
Callable Bond Options
Callable bonds are one type of embedded bond option. With callable bonds, the issuer has the option to repay investors the face value of the bond before the maturity date.
Recommended: Popular Options Terminology You Should Know
Bond Options Pricing
Given all the variables, including the current price and future price of a bond, volatility levels, interest rates, and time to expiration, it can be very complicated to properly price a bond option. Investors rely on several different mathematical formulas for this, including the Black-Derman-Toy Model and the Black Model.
Options traders may use a bond option as a hedge against economic volatility in key areas like interest rates, currency rates, and bond yield rates, a bond option can be a useful portfolio management tool. However, there are plenty of other types of investments that an investor can use when building a portfolio, without trading bond options.
While SoFi does not currently offer bonds or bond options, you can create an investment portfolio on the SoFi Invest trading app composed of stocks, exchange-traded funds, and even cryptocurrency. You can either select the securities in your portfolio yourself or use the automated service to have a customized portfolio built for you.
Photo credit: iStock/PeopleImages
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A., or SoFi Lending Corp.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.