Calendar Spreads Carry Several Risks

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A reader asks, "Could you write something about the implied volatility risk of calendar spreads? For instance, I'm considering an Altria (MO) spread of the September $70 or January 2008 call (short) and being long the January 2009 call. The theta ratio is over 2 to 1, but what about the possible accelerated collapse of the long option as MO pays dividends?"

The reader correctly identifies time decay, or theta, as what primarily allows an at-the-money calendar spread to yield a profit. That is because theta is defined by a slope in which the rate of time decay accelerates as expiration approaches.

The value of the near-term option sold short will erode more than the longer-term option that is owned; all else being equal, the spread will increase in value as the longer-term option retains more time premium relative to the shorter-term option.

But the reader is also right to recognize that this strategy comes with several risks, just one of which is dividends. In the case of Altria, the options will be pricing in the dividend payments, but once the stock price rises above $70 and pushes the call sold short into the money, you risk the possibility of early assignment. Remember, the owner of an option does not collect the dividend; you must exercise the call and own the underlying shares to qualify for a dividend distribution.

With Altria now trading at about $69, one could sell the $70 call with the January 2008 expiration for $4.50 and buy the $70 January 2009 call for $7, a net debit of $2.50 for the calendar spread. The best-case scenario is if the stock remains right at $69 for the next seven months and you end up owning the '09 call for $2.50. But you will have forgone about $2 in dividend payments and have carried the aforementioned risk of early assignment.