What is a Wasting Asset?
A wasting asset is an item that has a limited life span and irreversibly declines in value over time. Such fixed assets could be vehicles and machinery. However, in the financial markets, the term refers to options contracts since the contract will continually lose time value after purchase.
- A wasting asset declines in value over time.
- Vehicles and machines are examples of fixed assets that are wasting assets.
- Contracts, an oil well, or coal mine are other examples of wasting assets.
- In the financial markets, options are a wasting asset because their time value continually diminishes to zero at expiration.
Understanding a Wasting Asset
With regards to investing, options are the most common type of wasting asset. An option's value has two components: time value and intrinsic value. As the option's expiration date nears, the time value of the option gradually declines to zero. At expiration, an option is worth only its intrinsic value. If it is in-the-money, its value is the difference between the strike price and the underlying asset's price. If it is out-of-the money, it expires worthless.
In a similar manner, other derivative contracts, such as futures, have a wasting component. As a futures contract nears expiration, the premium or discount it has to the spot market decreases. However, the value of the futures contract merely approaches the spot value, so in a strict sense it is not a wasting asset. Only the premium or discount wastes away as the futures contract is still worth something at expiration, unlike an out-of-the-money option at expiration.
Investors should be aware of the time left to expiration for any derivative, but for options in particular. Therefore, options strategies tend to be shorter-term in nature with most expiring within one year. There are longer-term options called long-term equity anticipation securities (LEAPS), which expire in one year or longer.
Options traders can also write options to take advantage of time value decay. Writers, or sellers, of options collect money when they write the contract and they get to keep the entire amount, called the premium, if the option expires worthless. In contrast, the buyer of the options loses the premium if the option expires worthless.
Any trader making a directional bet on the underlying asset by buying options can still lose money if the underlying does not move in the desired direction quickly. For example, a bullish trader buys a call option with a strike price of $55 when the current price of the underlying stock is $50. The trader will make money if the stock moves above 55 plus the premium paid, but it must do so before the option expires.
If the stock moves up to $54, the trader called the direction of the move correctly but still lost money. If the option costs $2, even if the stock price rises to $56, the trader still loses money even though the price rose above the strike price ($55). They paid $2 for the option, so the stock needs to rise above $57 ($55 + $2) to make a profit.
Other Wasting Assets
Outside of the financial markets, any asset that decreases in value over time is a wasting asset. For example, a truck used for business purposes will decrease in value over time. Accountants attempt to quantify the amount of the decrease by assigning a depreciation schedule, therefore recognizing the decrease in value each year.
While most vehicles and machines are wasting assets, there are a few exceptions. A rare car, for instance, may actually become more valuable over time as it becomes collectible. That said, the value often declines initially, yet over a long period of time the car becomes more valuable again if it is well maintained. Generally, though, vehicles are wasting assets with their value gradually declining until they are only worth scrap metal/parts.
A term life insurance policy has a time of expiration and therefore will expire worthless. So does a service contract, for repairs or other maintenance services, because the holder pays up front and the contract is only valid for a certain period of time. Once the contract ends, the value of the contract has been used up and is gone.
Finally, a natural resource supply, such as a coal mine or oil well, has a limited lifespan and will decrease in value as the resource is extracted and the remaining supply depleted. The owner calculates the depletion rate to arrive at an expected life span.
Example of an Option as a Wasting Asset
This option has no intrinsic value, since it is at-the-money and not in-the-money. Therefore, the premium reflects the time value of the option. The option, which expires in two months, has a premium of $2.55. The option costs $255, since an option contract is for 100 shares ($2.55 x 100 shares).
For the call buyer to make money, the price of GLD will need to rise above $129.55 ($127 + $2.55). This is the breakeven point.
If the price of GLD is below $127 at expiry, the option will expire worthless and the trader loses $255. On the other hand, the writer of the option makes $255. The writer has captured the time value or wasting asset portion of the option, while the buyer has lost it.
If the price of GLD is trading above $127 at the option's expiry, there is a possibility of a profit. If GLD is trading at $128, even though GLD is above the strike price the buyer will still lose money. They are profiting $1, but the option cost $2.55, so they are still down $1.55 or $155 which is the option writer's profit.
If the price of GLD is above $129.55 at expiry, say $132, then the buyer will be making enough on the option to cover the cost of the time value. The buyer's profit is $2.45 ($132 - $129.55), or $245 for the contract. The writer is losing $245 if they wrote a naked call option, or has an opportunity cost of $245 if they wrote a covered call.