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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) - Get Report

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.

Other risks include a change in price. The value of the calendar spread will decrease as the strikes move either deeper into the money, at which point they will both trade at intrinsic value, or if price declines, as a debit position, the value of the spread will also decrease.

Likewise, as a debit position, the implied volatility risk, otherwise known as vega risk, means that a decline in IV would hurt the value of the position. Conversely, a rise in IV would benefit or increase the value of the position.

If you're looking to use a calendar spread as a means of taking advantage of time decay, then consider options with shorter expiration dates. For example, you could sell short the June $70 call and purchase the September $70 call for a net debit of around $1.80 for the spread. You are still betting that the stock sits at $70, but in this case, you're only hoping for the stock to stand still for five weeks. That offers a higher probability than the shares staying at $70 for seven months.

Most people use calendar spreads with the intention of reducing the cost of the longer-dated option affective cost basis. The expectation is that the near-term option sold short will expire worthless, and then one can roll the position by shorting the next near-term option. In theory, this sounds great: Rinse and repeat until the cost of the long-term option is reduced to essentially a free position. The problem in reality is creating a calendar spread in which the long and short options are separated by more than one expiration period; it is no longer a single position.

In the example here in which the call purchased is 12 months from the option sold short, the position is actually made up of 12 separate situations in which a decision needs to be made each expiration cycle. That means you have 12 chances to be wrong.

My preference for using longer-term calendar spreads is to use out-of-the-money strikes. This provides a lower-cost way to still take advantage of time decay, removes some of the risk of early assignment associated with dividends and also adds a directional bias and allows the position to benefit from a price move.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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