How Covered Calls Work | The Popular Options Strategy
- FinancialWisdom
- 1 hour ago
- 7 min read
Create a monthly income through options selling.
Today, we will talk about a strategy that, if executed well, can help you generate monthly cash flow from stocks you already own—while reducing your risk and giving you more control over your investments. That’s exactly what Alan Ellman’s Complete Encyclopedia for Covered Call Writing claims. If you want to learn how to turn your portfolio into a consistent income machine, keep watching.
Covered call writing is a strategy that’s stood the test of time. Alan Ellman, a dentist-turned-investor, used it to build wealth from scratch—eventually owning multiple properties and achieving financial independence. His book isn’t just theory; it’s a practical, step-by-step guide, packed with flowcharts, calculators, and real examples. Today, I’ll show you how the covered call works, why it’s so powerful, and how you can use it to create your own ‘monthly paycheck’ from the stock market using the stocks that you already own. By the end, you’ll have a blueprint for building wealth with discipline, simplicity, and low risk.
Let’s start with the basics. Imagine you own a house worth $100,000. You’re happy to keep it, but if someone offered you $120,000 in the next six months, you’d sell. Now, 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 get $120,000 plus the $10,000. That’s the essence of a covered call.
In the stock market, you buy 100 shares of a company, then sell a call option—giving someone else the right to buy your shares at a set price (strike price), by a set date. In return, you collect a premium, instantly. If the stock stays below the strike price, you keep the shares and the premium. If it rises above, you sell at the agreed price—locking in a profit plus the premium.
This is not just theory. Ellman’s book is filled with real-life examples, like buying 100 shares of a stock at $48, selling a $50 call for $1.50, and collecting $150 in premium. If the stock stays below $50, you keep the shares and the premium. If it rises above $50, you sell at $50, pocketing $200 in capital gains plus the $150 premium—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 in. 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 discuss these exit strategies later in the video.
The call options traded here are the same-month expiration. Options typically expire on the third Friday of every month.
Let's now understand why Covered Calls Work and its The 10-Point Edge
Ellman’s book lays out ten reasons why covered calls are a favourite of professional and retail investors alike. Here are the highlights:
First, covered calls have delivered the highest returns for low risk. Ellman’s own results: covered calls outperformed every other low-risk strategy he tried over 20 years.
Second, they work in tough markets. Sideways, slightly up, or slightly down—covered calls generate income when stocks aren’t strongly trending. In strongly uptrending markets, it is best to simply own the stocks and not sell the options, as selling the options caps potential profits. In strongly downtrending markets, it’s best to step away and sit on cash.
Third, you get instant cash flow. Premiums hit your account immediately—no waiting for dividends.
Fourth, you get the power of compounding. Reinvest premiums for exponential growth.
Fifth, you get some downside protection. Premiums cushion losses if the stock drops.
Sixth, you have control and flexibility. You choose the stock, the strike, and the timing.
Seventh, it’s a transferable skill. Teach it to your kids, use it for your parents’ accounts.
Eighth, you capture dividends. You own the stock, so you get the dividends.
Ninth, you can beat the market. Most mutual funds underperform. Covered calls can outperform.
And tenth, it’s IRA-friendly - it’s relatively safe, and the government allows it in retirement accounts.
Ellman’s approach is about maximizing profits while minimizing risk. He’s not promising you’ll get rich overnight, but he does show how you can build wealth steadily, month after month, year after year.
Let’s now understand 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:
First, you must tolerate some risk. This is a low-risk, not a no-risk, strategy. Stocks can still drop. You must be able to handle volatility. The market will whipsaw, and you need to react intelligently, not emotionally.
Second, only sell calls on stocks you want to own. Don’t chase high premiums on junk stocks. Quality first, premium second. The best approach is to select only the greatest performing stocks, from both a fundamental and technical standpoint, that are also located within the greatest performing industry groups.
Third, 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 strategy plans, and those who buy the stock, sell the option, and pray for a happy outcome. Don’t be the latter.
4. The Covered Call Process: Step-by-Step (8:00-12:00)
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 a watchlist of 40-60 of these 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 are those with a 20-day EMA above the 100-day EMA, and price bars at or above the 20-day EMA.
Step 3: Option Selection
Choose a strike price based on your outlook. Out-of-the-money for more upside, 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 is used to “buy down” the cost of the stock, providing downside protection.
Step 4: Trade Execution
Buy the stock, sell the call. Use limit orders, 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 is closing an existing options position, and simultaneously opening another options position (by selling a call option) at a lower strike price in the same contract month
On the other hand, if the stock rises, be ready to roll out or let it be assigned (settled). 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, which is also called Buy-to-Close or B-T-C. And simultaneously, selling (Sell-to-Open or S-T-O) a new call option contract that has the same strike price as the original option but a later expiration date, usually the next month. This action is considered a "package trade" and is designed to allow you to retain ownership of the underlying stock while continuing to generate cash flow
Ellman’s system also has other exit strategies like hitting a double, converting dead money to cash profits, and the mid-contract unwind, which are very well explained in the book
Now, let’s talk about risk management - The Foundation
Legendary traders know: 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. And always, 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.
Here are some common pitfalls and how you can avoid them
Most covered call writers fail for three reasons:
First, 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.
Second, 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 ready to roll out or let it be assigned.
Third, 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.
And 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.
Alan Ellman’s Complete Encyclopedia for Covered Call Writing is more than 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 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 is worth your attention. Ellman’s book is packed with practical tools, flowcharts, and calculators to help you succeed. It’s a must-read.
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