Yes, that option is there mostly for legacy software/hardware purposes to support CHAP authentication. You shouldn't enable that setting otherwise.
The reason passwords have to be encrypted, rather than hashed, on the server is because the CHAP authentication protocol was designed with a different threat in mind. They were more worried about the password being sent over the network in plaintext (these were the days of telnet, ftp, and http so that was an accomplishment). So they implemented a process by which the server sent a random challenge or nonce string to the client that needed to be hashed by the client along with the password. This prevented people from sniffing the password off the network during transmission.
But since the server needed to calculate whether the client response was valid it also needed access to a plaintext copy of the password to hash with the challenge. So they encrypt the password to allow the server to decrypt it temporarily and make this comparison using the plaintext.
Today when newer protocols (like NTLM or Kerberos) want to implement this same network level of protection they just calculate the hash of the password first on the client before making the other transformations. That way they only need store a cryptographic hash of the password on the server.