Case Study: Finding a Stock for Covered Calls

Theory only goes so far. At some point, you need to apply the process to real situations. This case study walks through finding a stock suitable for covered calls from start to finish. We'll screen, analyze, value, and assess options characteristics, showing exactly how the pieces fit together. By the end, you'll see the complete workflow for identifying covered call candidates.

TL;DR

• Start with quality: Screen for profitable, stable businesses with strong balance sheets
• Add value criteria: Focus on stocks trading near or below intrinsic value
• Check options characteristics: Verify adequate premiums and liquidity before committing
• Avoid earnings windows: Confirm no major announcements before your expiration
• Use Wall St Yardie for valuation: Calculate intrinsic value to ensure you're buying at the right price

The Setup: What We're Looking For

Covered calls work best on stocks you'd happily own for the long term. You're selling someone else the right to buy your shares at a higher price, collecting premium while waiting. If called away, you sell at a profit. If not called, you keep the premium and the shares.

The ideal covered call stock has these characteristics:

• Quality business: Strong competitive position, consistent earnings, healthy balance sheet
• Fair or undervalued: Trading at or below intrinsic value so you're not overpaying
• Moderate volatility: Enough price movement to generate reasonable premiums without wild swings
• Liquid options: Tight bid-ask spreads for efficient entry and exit
• Clear calendar: No earnings or major events before option expiration

Let's find one.

Step 1: Run the Initial Screen

Using a free screener like Finviz, we set these filters:

Quality filters:

• Market cap > $10 billion (large, established companies)
• EPS growth past 5 years > 5% (growing business)
• EPS positive last year (profitable)
• ROE > 12% (decent returns on capital)
• Debt/equity < 1.0 (conservative balance sheet)
• Current ratio > 1.5 (liquid position)

Value filters:

• P/E < 20 (not expensive relative to earnings)
• P/E > 8 (not suspiciously cheap, avoid distressed situations)
• Earnings yield > 5%

Options-relevant:

• Option/Short: Yes (has traded options)

Running this screen today returns 47 stocks. That's a manageable list for manual review. Let's examine one candidate in detail.

Step 2: Select a Candidate for Deep Dive

From our screened list, one stock catches attention: a consumer goods company we'll call "ConsumerStaples Inc." (fictional for illustration purposes). Here's its profile:

• Business: Manufactures household cleaning products and personal care items
• Market cap: $35 billion
• P/E ratio: 16.5
• EPS growth (5-year): 7% annually
• ROE: 18%
• Debt/equity: 0.65
• Dividend yield: 2.8%

On the surface, this looks like a quality business at a reasonable price. But we need to go deeper.

Step 3: Analyze Business Quality

Reading through the company's investor presentations and recent earnings calls reveals:

Competitive advantages:

• Leading market share in several product categories
• Strong brand recognition built over decades
• Extensive distribution network creating barriers to entry
• Pricing power demonstrated during recent inflationary periods

Earnings consistency:

• Positive EPS every year for 15+ years
• Earnings dipped only 5% during the 2020 pandemic, recovering within 6 months
• Margins stable around 15% operating and 10% net

Balance sheet strength:

• Manageable debt levels with investment-grade credit rating
• Interest coverage ratio of 12x (earnings easily cover debt payments)
• Strong free cash flow generation funding dividends and buybacks

This is exactly what we want: a boring, predictable business that compounds steadily. Consumer staples aren't exciting, but excitement isn't the goal for covered call income. Consistency is.

Step 4: Calculate Intrinsic Value

Using Wall St Yardie, we input the company's financials:

• Current EPS: $5.20
• Estimated growth rate: 6% (conservative, slightly below historical)
• Discount rate: 10% (required return)

The discounted growth model suggests intrinsic value around $95 per share. The stock currently trades at $86. That's a 9.5% discount to our calculated fair value.

A 10% margin of safety isn't massive, but for a stable consumer staples company with consistent earnings, it's acceptable. We're not buying a speculative situation. We're buying a quality business at a fair price, then enhancing returns through covered calls.

If we demanded a 25% discount, we might wait years for an entry point on this type of stock. The covered call premium helps compensate for buying at only a modest discount.

Step 5: Check Options Characteristics

Now we verify the options market suits our strategy.

Pulling up the option chain:

The $90 call expiring in 30 days shows:

• Bid: $1.25
• Ask: $1.35
• Spread: $0.10 (tight, indicating good liquidity)
• Open interest: 3,200 contracts (adequate volume)
• Implied volatility: 22%

Calculating potential returns:

If we buy 100 shares at $86 and sell the $90 call for $1.30 (midpoint):

• Premium collected: $130 per contract
• Return if not called: $130 / $8,600 = 1.5% for 30 days (18% annualized)
• Return if called: ($90 - $86 + $1.30) / $86 = 6.2% for 30 days

Both outcomes are attractive. We either collect 1.5% monthly income on a stock we're happy to own, or we make 6.2% in a month if the stock rises above our strike.

Checking implied volatility:

At 22% IV, this stock has moderate volatility. Historical volatility is similar, suggesting options are fairly priced. We're not getting an unusual premium spike, but we're also not selling into a dangerously volatile situation.

The IV percentile is 45%, meaning current volatility is roughly average for this stock. That's fine. We're not trying to time volatility. We want consistent, repeatable income.

Step 6: Verify the Calendar

Before committing, check the earnings schedule. ConsumerStaples Inc. reported earnings 3 weeks ago. The next report is 10 weeks away. Our 30-day option expires well before any major announcement.

No other significant events appear on the horizon: no investor days, no major product launches, no regulatory reviews. The calendar is clear.

This stock passes all checks.

Step 7: Execute the Trade

The complete position:

1. Buy 100 shares of ConsumerStaples Inc. at $86 = $8,600 invested
2. Sell 1 contract of the $90 call expiring in 30 days for $1.30 = $130 premium received
3. Net cost basis: $86.00 - $1.30 = $84.70 per share

Possible outcomes:

• Stock stays below $90: Keep shares and $130 premium. Sell another call next month.
• Stock rises above $90: Shares called away at $90. Total gain: $530 ($400 capital gain + $130 premium).
• Stock drops significantly: Still own shares but cushioned by $1.30 premium. Continue holding a quality business and sell calls going forward.

We've entered a position on a quality company at a fair price, collected income immediately, and defined our possible outcomes. That's the covered call process working as intended.

Analyzing the Trade-Offs

This case study illustrates several key covered call dynamics:

Why we picked the $90 strike:

At $90, we're selling a call 4.6% above our purchase price. That's enough upside to provide meaningful profit if called, while the strike is close enough to generate reasonable premium.

We could have sold the $95 call for $0.45, but that's only 0.5% monthly return. Or the $87.50 call for $2.10 (2.4% return), but we'd be capping gains just 1.7% above our cost.

The $90 strike balances income against upside potential.

Why 30 days to expiration:

Monthly options provide the best balance of time decay (theta) working in our favor while maintaining flexibility. Longer expirations tie up the position. Shorter expirations require more frequent trading and incur more commissions.

After 30 days, if shares remain in our account, we evaluate again: sell another call at the same strike, adjust based on the stock's new price, or wait for better conditions.

Why this stock over alternatives:

Our screen returned 47 candidates. ConsumerStaples Inc. stood out because:

• Business quality was clearly above average
• Valuation was reasonable without being suspiciously cheap
• Options liquidity was excellent
• No earnings or event risk in the trade window

Other screened stocks might have had better valuations but worse options liquidity, or attractive premiums but earnings looming. The complete package matters for covered calls.

What Could Go Wrong?

Stock drops sharply: If ConsumerStaples Inc. falls 20% on broader market panic, we're down $1,720 minus our $130 premium. The covered call doesn't prevent losses, just cushions them slightly. We'd continue holding a quality business and selling calls at lower strikes until the position recovers or we cut our losses.

Stock rockets higher: If unexpected news sends the stock to $110, we sell at $90 and miss substantial gains. That's the covered call trade-off: capped upside in exchange for immediate income.

Premiums shrink: If volatility collapses, future calls might yield only 0.8% monthly instead of 1.5%. The strategy still works but generates less income. Quality businesses with temporarily low IV are still worth holding.

Company fundamentals deteriorate: If the business weakens, we need to re-evaluate whether to hold. Covered calls don't fix fundamental problems. Regularly reassess your positions regardless of options overlay.

Next Steps

• Run your own screen: Use the quality and value filters above to generate candidates in your market.
• Deep dive on 3-5 stocks: Don't stop at screener results. Read financials, check competitive position, understand the business.
• Calculate intrinsic value: Use Wall St Yardie to ensure you're paying fair prices.
• Check option chains: Verify adequate premium and liquidity before committing capital.
• Verify calendar is clear: No earnings or events before expiration.
• Start small: Try one covered call position before scaling to multiple names.
• Read related concepts: Review Choosing the Right Stock for Covered Calls for detailed selection criteria. See Strike Price Selection for optimizing your strike choice.

Case studies translate theory into action. The process isn't complicated, but it requires discipline: screen systematically, analyze thoroughly, value objectively, and verify options characteristics before trading. When each step checks out, you've found a covered call candidate worth your capital. Keep the riddim steady, follow the process, and let compounding do its work.