Author: DD dropsdrops; Source: X, @rtk17025

In a bear market, many people will choose to put money into financial management, but in the current environment, thunderstorms in DeFi projects have become the norm.

And if you don’t understand what magic the project side is playing, you are actually just meat on their chopping board.

So this time I want to start with the most basic logic. Let’s learn the bottom layer of DeFi: options.

1. How humans first bought a choice for the future

Imagine traveling back in time to the deserts of the ancient Middle East thousands of years ago.

The protagonist of the story is called Jacob. He traveled a long distance to his uncle Laban's home and fell in love at first sight with Laban's youngest daughter Rachel. Jacob wanted very much to marry Rachel, but he was a penniless fugitive at the time and could not afford the generous dowry required by society at that time.

According to the general spot transaction (paying the money with one hand and delivering the goods with the other hand), Jacob was not qualified to negotiate this marriage at all. Moreover, if he had spent a few years slowly saving money, the beautiful Rachel might have been betrothed to another rich kid.

Faced with the huge risk of "an uncertain future", what should Jacob do?

He made a proposal to Laban: "I am willing to work for you for seven years for free in exchange for the right to marry Rachel after seven years."

Laban agreed. The two parties concluded a contract against time and the future.

This is actually the four core elements of choice.

• Buyer: Jacob. He is the one who wants to control the future.

• Seller: Laban. He accepted the benefit and promised to fulfill his obligations in the future.

• Underlying Asset: The right to marry Rachel. In modern times, this could be Bank of America stock, Bitcoin, or gold.

• Premium: Seven years of free labor. In order to "buy this right," Jacob had to pay a price first. It's like the premium we pay when we buy insurance. Once we pay it, we can't get it back, but what we get in exchange is future protection.

• Expiration Date: After seven years. The contract stipulates a specific time point for fulfilling the promise.

What problem did Jacob solve through this contract?

He used his current labor force (royalty) to lock in a future price and rights, eliminating the risk of Rachel marrying someone else within these seven years. This is the most fascinating thing about choice: it gives people the ability to fight against the uncertainty that time brings.

The earliest DeFi thunderstorm: Counterparty Risk

The interesting thing about this story is that in the second half of the story, the most original DeFi thunderstorm incident was also included, and the project team secretly changed people

After the seven years have expired (the expiration date has arrived), Jacob is ready to exercise his right (ask to marry Rachel). As a result, the cunning seller Laban actually broke the contract on the night of the wedding! He secretly exchanged his eldest daughter Leah for Rachel to marry Jacob.

This is Counterparty Risk, which means that the other party to the contract is not trustworthy, resulting in the failure of the contract to be performed as scheduled.

This is the earliest DeFi thunderstorm.

2. How can one contract trade the future?

In Jacob's case, he locked in a future promise with seven years of labor. The mechanism of modern financial markets is to convert this verbal commitment into a standardized contract, which is a string of codes in the computer system. As for why a contract can be used to trade the future, and even the price will fluctuate violently, it can be understood through the daily behavior of buying a house and placing an order.

Understand the essence of options from the deposit for buying a house

Suppose someone has his eye on a house in the city worth $10 million. Market rumors suggest that a nearby MRT station may be announced next month. If the MRT station is confirmed to be built, house prices may soar to 15 million; if the rumors fail, house prices may drop to 8 million.

Buyers have insufficient funds on hand or are unwilling to take the risk of falling house prices. So a plan was proposed to the homeowner: pay 100,000 yuan first, which will not be refunded. In exchange, the owner provides a contract that gives the buyer the right to buy the house for $10 million within three months, no matter how much the price increases.

Considering the current market conditions, the owner believes that 100,000 yuan is a certain cash income. Even if the buyer gives up the purchase three months later, the house will still be retained and 100,000 yuan has been pocketed, so he agrees to sign. This model is a standard call option transaction in the financial market.

Why is this contract valuable?

Assume that the MRT station is confirmed to start construction one month later, and house prices soar to 15 million. At this time, the contract underwent a qualitative change. According to the contract, the buyer has the right to buy a house with a market price of 15 million for 10 million. Just execute the contract and resell the house, netting you $5 million. This means that the contract itself is worth at least 5 million.

This reflects the two core characteristics of options:

• First, the separation of rights and obligations. A general sales contract is a two-way obligation, but the option is one-way. The buyer has rights but no obligations, and the seller has obligations but no rights. If the MRT is not built and the house price drops to 8 million, the buyer can give up the execution of the contract and the maximum loss is only the initial 100,000 yuan premium paid. The buyer bears limited risk of loss while retaining potential profit.

• Second, you can participate in the ups and downs without holding assets, forming a leverage effect. The buyer did not actually use the 10 million to purchase the property, but used the 100,000 yuan contract to control the increase in the 10 million asset. The actual return rate for earning 5 million on a house purchase is 50%, but through options, using 100,000 to earn 5 million, the return rate is 50 times. This explains why options have the high-leverage characteristic of using small to make big gains.

3. When do people need the right to choose?

Continuing the question from the previous paragraph, since the buyer enjoys the advantage of limited losses and unlimited profits, why is there anyone in the market willing to be the seller with unlimited potential risks? The answer lies in the fact that participants have completely different financial plans and needs when facing market uncertainty.

The operation of the options market is mainly driven by three motivations: risk hedging, speculation, and the creation of additional income.

The first demand is hedging, which is essentially the concept of buying insurance.

Suppose you hold a large spot cryptocurrency on an exchange. You are optimistic about the development of these assets in the long term, but are worried that general economic changes or regulatory policies will cause a sharp market correction in the short term. If you sell spot goods directly, you will miss out on the long-term upside, but if you hold on, you will have to bear the risk of a sharp decline in assets.

At this time, you can choose to buy a put option (Put Option). This contract gives you the right to sell the asset at an agreed price at a certain point in the future. If the market really collapses, although the spot in your hand will suffer a book loss, the put contract you hold will increase in value significantly, just making up for the decline in the spot. On the other hand, if the market continues to rise, you will at most lose the premium you originally paid for the contract, but you can still enjoy the rising dividends on the spot in your hand. It's like buying downside insurance for your portfolio, trading downside risk protection for a fixed cost.

The second demand is speculation, which is to use risk-controllable leverage to amplify potential rewards.

For traders who do not want to invest a large amount of principal to buy spot, options provide extremely high capital efficiency. For example, it is observed that a certain blockchain network (such as the Base ecosystem) is about to undergo a major upgrade, and it is expected that related tokens will experience explosive growth. Buying directly in the spot market requires a huge investment. If you buy a call option (Call Option), you only need to pay a relatively small amount of premium to control assets of equal value and participate in rising profits.

If the market judgment is correct, the contract value may increase several times that of the spot; if the judgment is wrong, the maximum loss will be limited to the initial premium paid. Unlike futures contracts, option buyers will not face the pressure of forced liquidation (liquidation) due to insufficient margin, which makes it a powerful tool for defining absolute risk boundaries.

The third need is to create revenue, which is the main reason why sellers are willing to assume obligations.

In financial markets, being an option seller is like running an insurance company. Judging from statistical data, the vast majority of option contracts have no performance value when they expire and eventually return to zero. The seller's business model is to continue to collect the royalties paid by the buyer by taking extreme risks with a small probability.

In addition, many large institutions or long-term holders will use the covered call strategy. If they already hold a large amount of spot and assess that the price will only consolidate in the short term and not rise sharply, they will choose to sell the call option. As long as the asset price does not exceed the agreed performance price at maturity, the seller can steadily earn this premium. When the market is moving sideways, this approach is tantamount to creating additional cash flow for the idle assets on hand.

The options market is formed by the interweaving of these three needs. Haveners seek protection, speculators seek leverage, and sellers provide liquidity and earn value from the passage of time. After understanding the fundamental motivations of the participants, we can further dissect the four basic transaction aspects in the contract and their respective rights and obligations.

4. Call, Put, Buyer, Seller: Rights and Obligations of Option

When entering the options market, the most confusing thing is the four basic quadrants. In fact, as long as we separate the contract types and participating roles, the logic behind it is very clear. The ever-changing options market is composed of two types of contracts and two types of identities.

First distinguish the types of contracts. Call is called a call option, which gives the holder the right to "buy" the underlying asset at an agreed price in the future. Think of it as a pre-order. Put is called a put, which gives the holder the right to "sell" the underlying asset at an agreed price in the future. Think of it as an insurance policy or a guaranteed purchase certificate.

Then distinguish the participating roles. The buyer pays a premium to obtain the rights conferred by the contract. The buyer has absolute initiative and can decide whether to execute the contract when the time comes. The seller collects the premium and assumes the obligations stipulated in the contract. The seller is in a passive state. Once the buyer decides to execute, the seller must cooperate unconditionally.

The cross combination of the above two forms the four basic strategies of options:

• Buying a call option (Long Call): Investors pay a premium and have the “right” to buy the underlying asset at an agreed price at a certain time in the future. The market view is bullish.

• Short Call: Investors sell call options, collect premiums, and bear the "obligation" that they may be required to "sell" assets at an agreed price in the future.

• Buying a put option (Long Put): Investors pay a premium to have the “right” to sell the underlying asset at an agreed price in the future. It is usually used to anticipate a market decline or to hedge the risk of asset decline.

• Selling put options (Short Put): Investors sell put options, collect premiums, and bear the "obligation" that they may be required to "buy" assets at an agreed price in the future.

1. Buy Call: A bullish strategy

This is the most intuitive way to do long. A call is bought when a trader is strongly optimistic that an asset will rise sharply in the future, but does not want to commit full capital. For example, an asset is expected to rise from its current price of $100 to $150. Traders can pay a premium of 5 yuan to buy a call with a strike price of 110 yuan. If the price really rises to 150 yuan, the trader has the right to buy at 110 yuan, deducting a cost of 5 yuan, and making a net profit of 35 yuan. If the price falls below 110 yuan, the trader gives up the contract and the maximum loss is only 5 yuan. This is a typical example of limited risk and unlimited profit.

2. Buy Put: A strategy to bet on a big drop or to avoid risk

This is like buying insurance on an asset. Traders will buy Put when they expect the market to collapse or want to protect their spot assets. Suppose you hold an asset worth $100 and are worried that it will plummet next month. The trader pays 5 yuan to buy a Put with a strike price of 90 yuan. If the market crashes to $50, the trader still has the right to sell the asset for $90. The value of Put will soar as the underlying price falls. This is also a strategy with limited risk and huge profit potential.

3. Sell Call: A bearish strategy

This is one of the strategies for earning premiums and is often used in markets where prices are expected to enter a consolidation or moderate decline. The seller collects the premium paid by the buyer and promises to sell the asset to the buyer at that price if the price exceeds the strike price. If there is no spot on hand but the call is sold (called naked short selling), the seller will face unlimited risk of loss once the asset price soars without an upper limit. Therefore, institutional legal persons usually adopt a covered call strategy based on the spot on hand to increase additional income when the market goes sideways.

4. Sell Put: A strategy that is bearish or opens a position at a target price

This is a strategy that is often overlooked but widely used by many value investors or quantitative traders. Puts are sold when the price is not expected to fall sharply, or when the asset is expected to be purchased at a lower target price. For example, if an asset is currently priced at 100 yuan, traders feel that 80 yuan is an excellent buying point. He can sell the Put with a strike price of 80 yuan and receive a premium immediately. If the price does not fall below 80 yuan at expiration, the contract will be void and the premium will be earned in vain. If the price falls below 80 yuan, the trader must fulfill his obligation and buy the asset at 80 yuan, which is exactly in line with his original plan to open a position at 80 yuan, and because the premium has been collected first, the actual purchase cost will be lower than 80 yuan.

These four quadrants form the foundation of all complex derivative financial products. The buyer exchanges limited risk for leverage and freedom of choice; the seller exchanges extreme risk for fixed income brought by the passage of time.

However, in the real trading world, the pricing of contracts is not simply bullish. The value of an option also involves the degree of market panic and the passage of time. This leads to the core of the quantitative model on Wall Street and the currency circle, and it is also the threshold that many advanced traders must cross.

5. From Wall Street to the Currency Circle: IV, Greeks and the Real Core of Options Risk

When options, a sophisticated set of financial instruments, were moved from the traditional Wall Street trading floor to the year-round cryptocurrency market, where prices fluctuate violently, the rules of the game fundamentally changed.

In the traditional stock market, investors may have been waiting for a quarter for TSMC's financial report, and market volatility is relatively predictable. But in the currency circle, breaking news over the weekend may cause Bitcoin or Ethereum to experience an amplitude of more than ten percent. In this extreme environment, when conducting quantitative arbitrage or establishing defensive positions, simply guessing the rise and fall of prices is far from enough.

If you imagine yourself standing in front of a giant blackboard and trying to dismantle all the variables that affect the price of a contract, you will find that the option pricing model is essentially a set of multi-dimensional calculus equations. In order to analyze these variables, financial scientists invented an indicator system called "Greeks".

The real starting point of this system is Implied Volatility (IV).

Implied Volatility: Pricing Fear and Greed

Before you can recognize the Greek letters, you must first understand IV. IV is not the historical magnitude of shocks that occurred in the past, but the collective consensus among market participants on the extent of future volatility.

When the market anticipates a big trend (for example, a Layer 2 network is about to undergo a major upgrade, or the Federal Reserve is preparing to announce an interest rate cut), people will frantically buy options for speculation or hedging. This rush buying behavior will push up the price of the contract. We reversely substitute this pushed-up price into the pricing formula, and the calculated value is IV.

To put it simply, IV is the fear and greed index in the options market. The higher the IV, the more unstable the market believes the future will be, and the more expensive the premium will be; the lower the IV, the cheaper the premium will be.

First level risk dashboard: Delta, Theta, Vega

With the concept of IV, we can open the option risk control dashboard. The three core indicators correspond to price, time and volatility respectively.

Delta represents price sensitivity, which is directional risk. It is defined as how much the price of the option will change when the price of the underlying asset changes by 1 yuan. You can think of Delta like the speedometer when driving. If your call delta is 0.5, this means that for every $1 that Bitcoin rises, your contract will increase in value by $0.5.

Theta stands for time decay, which is time risk. Options are assets with a shelf life, and Theta measures how much value your contract will lose every day, other conditions remaining unchanged. To the buyer, Theta is a ruthless taxi meter that deducts money every day, just like holding a melting ice cube in the hand; but to the seller, Theta is the interest that is automatically credited every day.

Vega stands for volatility sensitivity, or sentiment risk. It measures how much a contract's price will change when implied volatility (IV) changes by 1%. In the currency circle, Vega’s influence often overshadows Delta’s. Sometimes you clearly looked in the right direction, and Bitcoin did rise. However, because the market sentiment returned from extreme fanaticism to calm, IV dropped sharply, causing the losses caused by Vega to eat up the profits brought by Delta. This is called "Volatilization Crush" on Wall Street.

Advanced fine-tuning gears: Speed, Color, Ultima

If the financial market was only affected by the above three variables, then quantitative trading would be too simple. The reality is that when market prices change, Delta, Theta, and Vega themselves change as well. To account for this dynamic, higher order Greek letters were derived.

To understand higher order letters, we need to first mention Gamma. Gamma is the acceleration of Delta. It measures how much the delta itself changes when the asset price changes by 1 dollar.

Speed is the rate of change of Gamma. In physics, if Delta is velocity and Gamma is acceleration, then Speed ​​is jerk. It measures how quickly gamma itself changes as the price of the underlying asset continues to move. This is very important for managing very short-term, high-frequency positions where prices fluctuate violently.

Color measures the effect of time on Gamma. As the expiration date of the contract gets closer, the value of Gamma will change. Color tells traders how your acceleration (Gamma) will change every day.

Ultima is the third derivative of volatility. When IV changes, Vega changes, and the metric that measures the rate of change of Vega is called Vomma. Ultima further measures how Vomma will change when IV changes again. These extremely small values ​​are usually used only by institutions that manage hundreds of millions of dollars in capital and perform extreme arbitrage on the volatility curve.

Interdimensional ghosts: Vanna and Charm

In modern quantitative research, what really fascinates high-level traders are the Greek letters of cross-dimensional interaction, the most famous of which are Vanna and Charm.

Vanna measures the impact of changes in volatility (IV) on Delta. This sounds counterintuitive: Why does a change in volatility affect my sensitivity to price direction? Because when the market panics (IV rises), those contracts that were originally out of reach and extremely out-of-the-money suddenly become "likely to be realized." This expansion of possibilities pulls the delta distribution of the entire portfolio. When extreme market conditions occur in the currency circle, Vanna is often the driving force behind forcing market makers to buy and sell spot stocks frantically to hedge risks.

Charm measures the effect of the passage of time on delta, also known as delta decay. As time goes by, the chance of a comeback for an out-of-the-money contract with no performance value becomes increasingly slim. Charm describes how the delta of this contract returns to zero over time.

The real core of option risk

From the basic Delta to the complex Vanna, these letters reveal the ultimate truth of option trading: what you buy or sell is never a single-dimensional asset, but a four-dimensional space intertwined by price, time, fluctuation and probability.

Newbies die from direction (misreading Delta), veterans die from time (being consumed by Theta), and experts often die from volatility (backwashed by Vega and Vanna).

Of course, I wrote this article not just to teach you how to avoid risks, but to give everyone the ability to understand the five ghosts of DeFi projects.

You want his interest, and he wants your principal.

How to see through those complex structural commodities and protect yourself is the way to protect yourself in the bear market.