What Is a Wasting Asset?
A wasting asset is an item that has a limited life span and irreversibly declines in value over time. Examples include depreciating fixed assets such as vehicles and machinery and securities with time decay such as options, which continually lose time value after purchase.
- A wasting asset is one that declines in value over time.
- Vehicles and machines are examples of fixed assets that are wasting assets.
- Other examples of wasting assets include exhaustible resources such as an oil well or a coal mine.
- In the financial markets, options are a wasting asset because their time value continually diminishes until reaching zero at expiration.
Understanding a Wasting Asset
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 decrease by assigning a depreciation schedule to recognize the falling 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. 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 upfront 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.
A natural resource supply, such as a coal mine or oil well, has a limited lifespan, too, 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.
Wasting Assets in Financial Markets
In the financial markets, 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 gradually declines toward zero due to time decay. At expiration, an option is worth only its intrinsic value. If it is in the money (ITM), its value is the difference between the strike price and the underlying asset's price. If it is out of the money (OTM), 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 OTM option at expiration.
Investors should be aware of the time left to expiration for any derivative, especially when it comes to options. Options strategies tend to be shorter-term in nature with most expiring within one year. There are, however, 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, the trader loses money even if the stock price rises above the strike ($55) to $56. They paid $2 for the option, so the stock needs to rise above $57 ($55 + $2) to make a profit.
Example of an Option as a Wasting Asset
This option has no intrinsic value since it is ATM and not ITM. 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. The writer has captured the time value or wasting asset portion of the option, while the buyer has lost it.
If GLD is trading above the strike price at $128 at the option's expiry, the buyer will still lose money. They are fetching $1, but the option costs $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.