How Covered Calls Work | The Popular Options Strategy
- FinancialWisdom
- Nov 23, 2025
- 6 min read
Updated: 3 days ago
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Introduction to Covered Call Writing
Today, we will explore a strategy that can help you generate monthly cash flow from stocks you already own. This approach reduces your risk and gives you more control over your investments. Alan Ellman’s Complete Encyclopedia for Covered Call Writing claims that this method can turn your portfolio into a consistent income machine. If you want to learn how to achieve this, keep reading.
The Power of Covered Call Writing
Covered call writing is a time-tested strategy. Alan Ellman, a dentist-turned-investor, used it to build wealth from scratch. He eventually owned multiple properties and achieved financial independence. His book is not just theory; it’s a practical guide filled with flowcharts, calculators, and real examples. Today, I’ll explain how covered calls work, why they are powerful, and how you can use them to create your own ‘monthly paycheck’ from the stock market. By the end, you’ll have a blueprint for building wealth with discipline, simplicity, and low risk.
Understanding the Basics of Covered Calls
Let’s start with a simple analogy. Imagine you own a house worth £100,000. You’re happy to keep it, but if someone offered you £120,000 in six months, you’d sell. Now, suppose someone pays you £10,000 for the right,but not the obligation to buy your house at £120,000. If they don’t buy, you keep the house and the £10,000. If they do, you receive £120,000 plus the £10,000. This is the essence of a covered call.
In the stock market, you buy 100 shares of a company and then sell a call option. This gives someone else the right to buy your shares at a set price (strike price) by a specific date. In return, you collect a premium instantly. If the stock stays below the strike price, you keep both the shares and the premium. If it rises above, you sell at the agreed price, locking in a profit plus the premium.
Real-Life Examples of Covered Calls
This is not just theory. Ellman’s book is filled with real-life examples. For instance, you might buy 100 shares of a stock at £48, sell a £50 call for £1.50, and collect £150 in premium. If the stock stays below £50, you keep both the shares and the premium. If it rises above £50, you sell at £50, pocketing £200 in capital gains plus the £150 premium. This results in a 7.3% monthly return, or 87% annualized.
But what if the stock drops more than the premium received? That’s where your exit strategies come into play. You can roll down, close the position, or convert dead money to cash profits by selling the stock and moving the cash into a better-performing equity. We will discuss these exit strategies later in the article. The call options traded here typically expire on the third Friday of every month.
Why Covered Calls Work: The 10-Point Edge
Ellman’s book outlines ten reasons why covered calls are a favourite among professional and retail investors alike. Here are the highlights:
High Returns for Low Risk: Covered calls have delivered the highest returns for low risk. Ellman’s results show that covered calls outperformed every other low-risk strategy he tried over 20 years.
Effective in Tough Markets: They work in sideways, slightly up, or slightly down markets, generating income when stocks aren’t strongly trending.
Instant Cash Flow: Premiums hit your account immediately—no waiting for dividends.
Power of Compounding: Reinvest premiums for exponential growth.
Downside Protection: Premiums cushion losses if the stock drops.
Control and Flexibility: You choose the stock, the strike, and the timing.
Transferable Skill: Teach it to your kids or use it for your parents’ accounts.
Dividend Capture: You own the stock, so you receive dividends.
Market Outperformance: Covered calls can outperform most mutual funds.
10. IRA-Friendly: It’s relatively safe, and the government allows it in retirement accounts.
Ellman’s approach focuses on maximizing profits while minimizing risk. He doesn’t promise you’ll get rich overnight, but he shows how you can build wealth steadily, month after month, year after year.
The Three Golden Rules of Covered Calls
Success with covered calls isn’t about luck; it’s about discipline. Ellman’s three golden rules are non-negotiable:
Tolerate Some Risk: This is a low-risk, not a no-risk, strategy. Stocks can still drop, and you must handle volatility. The market will whipsaw, and you need to react intelligently, not emotionally.
Sell Calls on Stocks You Want to Own: Don’t chase high premiums on junk stocks. Quality first, premium second. Select only the best-performing stocks from both a fundamental and technical standpoint.
Always Have an Exit Plan: Stocks misbehave. Be ready to adjust, roll, or exit—don’t just hope for the best. There are two types of option sellers: those who are prepared to implement multiple exit strategies and those who buy the stock, sell the option, and pray for a happy outcome. Don’t be the latter.
The Covered Call Process: Step-by-Step
Here’s Ellman’s process, distilled into five actionable steps:
Step 1: Stock Selection
Start with fundamentally strong stocks. Use screens like IBD 50, SmartSelect Ratings, and analyst consensus. Only consider stocks with solid earnings, sales growth, and institutional support. Ellman recommends maintaining a watchlist of 40-60 equities, which is both adequate and manageable for most covered call writers.
Step 2: Technical Analysis
Look for uptrends, strong moving averages, and positive momentum. Avoid stocks about to report earnings or with erratic charts. Use moving averages, MACD, stochastic oscillator, and volume to confirm trends. The best candidates have a 20-day EMA above the 100-day EMA, with price bars at or above the 20-day EMA.
Step 3: Option Selection
Choose a strike price based on your outlook. Opt for out-of-the-money for more upside, or in-the-money for more protection. Calculate your return on option (ROO) and downside protection. For example, if you buy a stock at £56 and sell a £50 call for £8, only the £2 of time value is considered profit. The £6 of intrinsic value helps “buy down” the cost of the stock, providing downside protection.
Step 4: Trade Execution
Buy the stock and sell the call. Use limit orders and play the bid-ask spread for better fills. Never check ‘All or None’—it reduces your leverage. If you’re using a buy-write order, you can enter both legs of the trade at once, specifying a net debit.
Step 5: Position Management
Monitor your positions. If the stock drops, consider rolling down or closing. Rolling down involves closing an existing options position and simultaneously opening another options position at a lower strike price in the same contract month.
If the stock rises, be ready to roll out or let it be assigned. Rolling out involves a two-part transaction where the initial short option position is closed by buying back the option of the same strike price and expiry. You will then sell a new call option contract that has the same strike price as the original option but a later expiration date. This action allows you to retain ownership of the underlying stock while continuing to generate cash flow.
Ellman’s system also includes other exit strategies like hitting a double, converting dead money to cash profits, and the mid-contract unwind, which are well explained in the book.
Risk Management: The Foundation
Legendary traders know that risk management is everything. Ellman’s system is built on this foundation. Never risk more than you can afford to lose. Diversify across at least five stocks in different industries. Allocate equal cash to each position. Always have an exit plan.
If you’re using margin, be aware of the risks. Margin can magnify gains, but it can also magnify losses. Ellman recommends using margin only if you’re experienced and comfortable with the risks.
Common Pitfalls and How to Avoid Them
Most covered call writers fail for three reasons:
Chasing High Premiums: High premiums often mean high risk. Stick to quality. Don’t be tempted by stocks with huge option returns—they’re often the most volatile and risky.
Ignoring Exit Strategies: Don’t just hope. Have a plan for every scenario. If the stock drops, be ready to act. If it rises, be prepared to roll out or let it be assigned.
Overconcentration: Don’t put all your eggs in one basket. Diversify. Ellman recommends at least five stocks in different industries, with equal cash allocation to each.
Finally, don’t forget about taxes. Covered call writing in non-sheltered accounts can generate short-term capital gains. Ensure you understand the tax implications and maintain accurate records.
Conclusion: Building Wealth with Covered Calls
Alan Ellman’s Complete Encyclopedia for Covered Call Writing is more than just a book; it’s a blueprint for building wealth with discipline, simplicity, and low risk. The covered call strategy isn’t about getting rich quick. It’s about achieving consistent, repeatable results month after month. Focus on quality stocks, manage your risk, and let the power of compounding work for you.
If you’re looking for a strategy that works in most markets, provides instant cash flow, and gives you more control over your investments, covered call writing deserves your attention. Ellman’s book is filled with practical tools, flowcharts, and calculators to help you succeed. It’s a must-read.
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