DEFINITION of 'Bond Option'

A bond option is an option contract in which the underlying asset is a bond. Other than the different characteristics of the underlying assets, there is no significant difference between stock and bond options. Just as with other options, a bond option allows investors the ability to hedge the risk of their bond portfolios or speculate on the direction of bond prices with limited risk.


To understand a bond option, let’s briefly summarize the basics of options. A call option gives the buyer the right to purchase the underlying assets of the option at a specific price before the option expires. The buyer is not obligated to exercise his rights, however, the seller (or writer) of the call option is. When the buyer exercises his rights, the call writer must sell the underlying assets to him at the strike price agreed on. A put option gives the buyer the right to sell the underlying assets of the option at a specific price before the option expires. Like a call option, the writer of a put option is obligated to purchase the assets if the buyer exercises his rights to sell.

Bond Call Option

A bond option is a contract that gives an investor or issuer the right to buy or sell a bond by a particular date for a predetermined price. A buyer of a bond call option is expecting a decline in interest rates and an increase in bond prices. If interest rates decline, the issuer may exercise his rights to buy the bonds. Remember there is an inverse relationship between bond prices and interest rates – prices increase when interest rates decline, and vice versa. For example, an investor purchases a bond call option with a strike price of $950. The par value of the underlying bond security is $1,000. If over the term of the contract, interest rates decrease, pushing the value of the bond up to $1,050, the options holder will exercise his right to purchase the bond for $950. On the other hand, if interest rates had increased instead, pushing down the bond’s value below the strike price, the buyer will choose to let the bond option expire.

Bond Put Option

The buyer of a bond put option is expecting an increase in interest rates and a decrease in bond prices. The put option gives the buyer the right to sell a bond at the strike price of the contract. For example, an investor purchases a bond put option with a strike price of $950. The par value of the underlying bond security is $1,000. If as expected, interest rates increase and the bond’s price falls to $930, the put buyer will exercise his right to sell his bond at the $950 strike price. If an economic event occurs in which rates decrease and prices rise past $950, the bond put option holder will let the contract expire given that he is better off selling the bond at the higher market price.

Embedded Options in Bonds

Bond options are also used to refer to the option-like features of some bonds. A callable bond has an embedded call option that gives the issuer the right to “call” or buy back its existing bonds prior to maturity when interest rates decline. The bondholder has, in effect, sold a call option to the issuer. A puttable bond has a put option that gives bondholders the right to “put” or sell the bond before it matures to the issuer when interest rates rise.

Another bond with an embedded option is the convertible bond. A convertible bond has an option which allows the holder to demand conversion of bonds into the stock of the issuer at a predetermined price at a certain time period in future.

Market participants use bond options to obtain various results for their portfolios. Hedgers can use bond options to protect an existing bond portfolio against adverse interest rate movements; arbitrageurs use them to profit from the price differentials of similar products in different markets; and speculators trade bond options in the hope of making profit on short-term movements in prices.

  1. Put Bond

    A put bond is a bond that allows the bondholder to force the ...
  2. Conditional Call Option

    A conditional call option requires a bond's issuer to replace ...
  3. Bond Yield

    Bond yield is the amount of return an investor will realize on ...
  4. Bond Market

    The bond market is the environment in which the issuance and ...
  5. Bond Futures

    Bond futures are financial derivatives which obligate the contract ...
  6. Embedded Option

    An embedded option is a special condition attached to a security ...
Related Articles
  1. Investing

    Why Bond Prices Fall When Interest Rates Rise

    Never invest in something you don’t understand. Bonds are no exception.
  2. Investing

    Six biggest bond risks

    Bonds can be a great tool to generate income, but investors need to be aware of the pitfalls and risks of holding corporate and/or government securities.
  3. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  4. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  5. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
  6. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  7. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  1. What does it mean when a bond has a put option?

    A put option on a bond is a provision that allows the holder of the bond the right to force the issuer to pay back the principal ... Read Answer >>
  2. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
Trading Center