What is a wasted good?
A wasted asset is an item that has a limited useful life and that its value irreversibly diminishes over time. Examples include the depreciation of fixed assets such as vehicles and machinery and values that deteriorate over time, such as options, that continually lose value over time after purchase.
- An asset that goes to waste is one that loses value over time.
- Vehicles and machines are examples of fixed assets that are wasting assets.
- Other examples of wasted assets include exhaustible resources like an oil well or a coal mine.
- In financial markets, options are a wasted asset because their time value continually decreases to zero at expiration.
Understanding a wasted asset
Any asset that loses value over time is an asset that goes to waste. For example, a truck used for commercial purposes will lose value over time. Accountants attempt to quantify the decline by assigning a depreciation schedule to recognize the decreasing value each year.
While most vehicles and machines are wasting assets, there are some exceptions. A rare car, for example, can become more valuable over time. The value often decreases initially, however over a long period of time the car becomes more valuable again if it is kept in good condition. However, in general, vehicles are wasting assets and their value gradually decreases until they are only worth scrap / parts.
A term life insurance policy has an expiration date and will therefore expire worthless. The same is the case with a service contract for repairs or other maintenance services because the owner pays in advance and the contract is only valid for a specified period of time. Once the contract ends, the value of the contract has been used up and disappears.
A supply of natural resources, such as a coal mine or an oil well, also has a limited useful life and its value will decline as the resource is extracted and the remaining supply is depleted. The owner calculates the depletion rate to reach an expected useful life.
Waste of assets in financial markets
In financial markets, options are the most common type of wasted asset. The value of an option has two components: time value and intrinsic value. As the option expiration date approaches, the time value gradually decreases towards zero due to the fall of time. 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 price of the underlying asset. If it’s out of the money (OTM), it expires worthless.
Similarly, other derivative contracts, such as futures, have an attrition component. As a futures contract nears expiration, the premium or discount it has in the spot market decreases. However, the value of the futures contract is simply close to the spot value, so, strictly speaking, it is not a wasted asset. Only the premium or discount is wasted 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 maturity of any derivative, especially when it comes to options. Option strategies tend to be short-term in nature and most expire within a year. However, there are longer-term options called long-term stock anticipation securities (LEAPS), which mature in a year or more.
Option traders can also write options to take advantage of falling value over time. Option writers or sellers charge money when they write the contract and can keep the full amount, called a premium, if the option expires worthless. Rather, the option buyer loses the premium if the option expires worthless.
Any trader who makes a directional bet on the underlying asset by buying options can lose money if the underlying does not move quickly in the desired direction. For example, a bull 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 you must do so before the option expires.
If the stock rises to $ 54, the trader correctly marked the direction of the move, but still lost money. If the option costs $ 2, the trader loses money even if the stock price rises above the strike price ($ 55) to $ 56. They paid $ 2 for the option, so the stock must exceed $ 57 ($ 55 + $ 2) to make a profit.
Example of an option as a wasted asset
Suppose a trader buys an option contract on SPDR Gold (GLD) shares. The trust is trading at $ 127, so they buy a call option in the money (ATM) with a strike of $ 127.
This option has no intrinsic value as 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 earn money, the GLD price must exceed $ 129.55 ($ 127 + $ 2.55). This is the balance point. If the GLD price is below $ 127 at expiration, the option will expire worthless and the trader will lose $ 255. The writer has captured the time value or wasted asset portion of the option, while the buyer has lost it. .
If GLD is trading above the $ 128 strike price at option expiration, the buyer will continue to lose money. They’re getting $ 1, but the option costs $ 2.55, so they’re still under $ 1.55 or $ 155, which is the option writer’s profit.
If the GLD price is above $ 129.55 at expiration, say $ 132, then the buyer will earn enough from 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 subscriber is losing $ 245 if he wrote a naked call option or has an opportunity cost of $ 245 if he wrote a covered call option.