The Effects of Dividends on Option Prices
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The rate of decay of an option premium due to time decay (theta) increases the closer an option gets to expiration. The trader of a calendar spread tries to capitalize on this by selling the short-term option, which has a higher short-term time premium, and buying the long-term option at the same strike to hedge against movement in the stock.
What if the underlying stock pays a large dividend after the expiration of the short term option and before the expiration of the long term option? The long term option is discounted by the premium, the short term option is not.
The result is that the long-term option can be purchased at a discount, making the hedge against loss for the short-term option cheaper.
Consider the following calendar spread as an example:
It is early July and FRO is trading at $40 a share. FRO pays a $3.00 dividend and goes ex-dividend on September 20. The October $40 call, which normally would trade at a high premium due to the underlying stock's volatility, is trading at a discounted price of $2.20. The call is discounted because the stock will drop $3.00 when the dividend is paid in September. The August 40 call, which is not affected by the dividend, is trading at $2.00.
Short selling the August 40 call and buying the October 40 call will cost a mere 20 cents. At the August expiration, the time premium on the August call will be close to zero, and the time premium on the October call will be reduced, but still represent two months of premium. Any intrinsic value in the August call will be offset by the intrinsic value in the October call.
Take the simple scenario where FRO is trading at $40 near expiration. The August call is worthless, and the October call is worth approximately $1.10. The return on this trade is $1.10, but the risk is relatively low (20 cents).
There can be an advantage to trading calendar spreads on stocks with large dividends, particularly on stocks whose dividend varies and is unpredictable, because the long leg is discounted by the dividend and the short leg is not.
The Dividend Report shows stocks that have both high volatility and dividends.