Differences Between Bonds and Stock Options

What Exactly Are The Differences Between Bonds and Stock Options?

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Differences Between Bonds & Stock Options - Introduction

With the popularisation of investment alternatives apart from stocks, retail investors and traders inevitably confused themselves on the difference between most of these instruments and have mistaken for ages that some of them are the same thing.

One of the most common misunderstanding is that Bonds and Stock Options are the same thing. In fact, there are many amateur traders who refer to buying options as buying bonds and asked questions like "How much does the bonds in options trading cost?".

This tutorial shall clarify the difference between Bonds and Stock Options.

Differences Between Bonds & Stock Options - What exactly are Bonds?

The term "Bond" comes from the verse "to be bonded". When one person is bonded to another, that person is enslaved or is liable to perform duties for the person bonded to. The finance industry used the term "Bond" to refer to any contract that bonds a borrower of money to the lender , committing the borrower to repay the money owed on a fixed term. In layman terms, it is simply a formal IOU (I Owe You) written to you when you lend money to companies or the government.

Bonds pay the investor (the lender) a certain amount of interest either during the life of the bond or at the end of the bond when the principal amount is also repaid to the investor holding the bond. This is why Bonds are referred to as "Fixed Income Securities". Investors receive fixed, predictable income based on the interest rate payable in the bond contract and as long as the investors hold the bond to maturity, the investors also get back the principal amount lent from the borrower.

Because of this relative low risk of default and predictable fixed income, investment quality bonds do not usually come with a high interest rate and would largely be for investment rather than speculation purpose. The most popular bond of all are the US Government Treasury Bonds.

Differences Between Bonds & Stock Options - What exactly is Stock Options Trading?

Stock options are contracts that grant the buyer of the contract the right to buy a stock at a fixed price no matter what the price of the stock is in future (Through Call Options) or the right to sell one's stock at a fixed price no matter how low the stock may be in future (Through Put Options). Stock options are classified as contingent claims in the finance world in that the holder of stock options get to decide whether or not the exercise the rights in the contract instead of having those rights automatically and mandatorily executed.

Stock options do not pay a fixed return to its holder and depend on the direction of the underlying stock in order to make a profit. This is why stock options trading can be highly speculative if used purely for its leverage potential.

Differences Between Bonds & Stock Options - Comparison

Here's a comparison of some of the main differences between Bonds and Stock Options:

Holding Period
Bonds are usually held for as many as 30 years or more as a fixed income investment while stock options are usually held short term, seldom more than a month or two, in order to profit from a short term move in the underlying stock.

Nature of Investment
Bonds are buy and hold type of investment while stock options are trading instruments.

Expiration
Both Bonds and Stock Options expires upon a fixed expiration date. Bonds usually have extremely long lives that run into 30 to 50 years with the investor getting back the principal amount upon maturity. Stock options have extremely short life spans ranging from a month to a year and the investor gets back nothing (expires worthless) if the stock options remain out of the money upon expiration.

By now, it should be clear that Bonds and stock options trading are two totally different things with their own trading characteristics. Bonds should never be made a replacement for stock options trading and stock options trading cannot replace Bonds as well. Both trading instruments serves different purposes and should find their place in every well diversified portfolio.

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