Experienced investors can use cash-secured puts for a few things. A cash-secured put strategy can add income to your portfolio by collecting premiums from an option. Additionally, an investor can potentially lock in a purchase price for a portfolio stock holding.

If you’re considering cash-secured puts for your portfolio, make sure you know exactly how it works. Cash-secured puts are more complex than just buying or selling stocks. The strategy includes options on stocks that you are interested in buying.

A cash-secured put strategy also has its risks. Let’s start with the basics.

What is a Put Option?

Cash-secured puts involve selling put options. A put option gives the buyer the option, but not the obligation, to sell their stock at a predetermined price (strike price) on or before a predetermined date (expiration date) to the seller of the contract.

The strike price and expiration are standardized in the put option contract. The strike price can be above or below the underlying stock’s current price. The expiration date is typically a few days to a few months. Remember, call options contracts are for 100 shares of the underlying stock.

The price an option buyer pays for the options contract is called the premium.

Keep reading for more info on cash-secured puts.

Put Option Example

Say Apple (Nasdaq: AAPL) is currently trading at $160 per share. A put option for Apple stock with a strike price of $150, which expires in 20 days, could be bought or sold for a $2 premium. The seller would immediately collect a $200 ($2 x 100) premium from the buyer. If 20 days pass and Apple stock does not drop below $150, the call option expires worthless to the buyer. In this case, the seller profits the $200 premium.

On the other hand, let’s say the stock goes down to $140 per share before expiration. The option seller has still collected the $200 premium. The option buyer can now sell the 100 shares of Apple stock to the seller or settle the contract in cash. If the buyer chooses to settle in cash (usually the case), the seller owes the buyer the difference between the current and strike prices. In this case, $1,000 ($150-$140 x 100). On a net basis, the seller loses $800 ($1,000 loss on the call option: $200 premium).

Selling Cash Secured Puts for Income

In a cash-secured put strategy, you are the seller of put options contracts and hold cash in an amount that will cover the potential stock transaction of the option. Keeping with the example above, let’s say you own 1,000 shares of Apple stock. You also want to implement a cash-secured put strategy to generate income from collecting put option premiums.

In a cash-secured put transaction, you can sell ten call options to cover your 1,000 shares. If you don’t intend to buy the underlying shares, you might want to sell a put option with a strike price well below the current $160 share price. Say $120. In this case, the put option premium will be much lower because there is a lower chance that the stock will reach $120 than $150 within the next 20 days.

The premium for a $120 strike call option may be closer to $.05 or $50 per contract.

Selling Cash Secured Puts to Buy Stock

Let’s say that you would like to buy Apple stock at $120 per share. In this case, you could sell put options with a $120 strike price and collect the premium. If the stock declines below $120 per share, you can use the cash you set aside to buy the stock from the buyer or cover the cash settlement (the buyer chooses cash or delivery).

In addition to potentially buying shares at a desirable price, you’ve collected the call option premium.

How to Sell Cash Secured Puts

Remember, options contracts are based on 100 shares of the underlying stock. Whether your goal is to generate income or lock in a purchase price for the underlying stock, the amount is the same.

If you want to implement a cash-secured put strategy on your 1,000 shares of Apple, you’ll need to sell ten contracts.

Risks of a Cash Secured Put Strategy

A cash-secured put strategy is less risky than selling a put option without cash to secure the transaction (naked put option). In a naked put option contract, the stock could fall below the strike price before the expiration. You may need to sell other stocks or owe money to your broker to cover your losses if this happens.

Since options buyers typically chose to settle in cash, you may not get the ability to buy the shares you want.