Understand the four quadrants of options: buyers have limited risk, sellers earn time value

Writing: DD滴滴./

In a bear market, many people choose to put their money into financial management.

But in the current environment, project explosions in DEFI have become the norm.

And if you don’t understand what tricks the project team is playing, you’re just meat on their chopping board.

So this time, I want to start from the most basic logic, and learn about the underlying options of DEFI.

Contents

1. How humans first bought a choice for the future

2. Why a contract can trade the future

3. When do people need options

4. Call, Put, Buyer, Seller

5. From Wall Street to the crypto world: IV, Greeks, and the true core of options risk

6. How humans first bought a choice for the future

Imagine going back thousands of years to the ancient Middle Eastern desert.

The protagonist of the story is Jacob. He traveled a long way to his Uncle Laban’s house and fell in love at first sight with Laban’s youngest daughter, Rachel. Jacob was eager to marry Rachel, but he was a penniless fugitive at the time, unable to afford the generous bride price demanded by society.

If it were a typical spot trade (pay first, deliver later), Jacob had no qualification to discuss this marriage. Moreover, if he saved money slowly over several years, the beautiful Rachel might have been betrothed to someone else long ago.

Faced with the huge risk of “uncertainty about the future,” what should Jacob do?

He proposed to Laban: “I am willing to work for you for free for seven years in exchange for the right to marry Rachel after seven years.”

One day, Laban said to him: “Although we are relatives, I can’t let you work for me for free. Tell me, what do you want in return?” 16 Laban has two daughters, the older named Leah, the younger Rachel. 17 Leah’s eyes are dull, [a], while Rachel is beautiful and outstanding. 18 Jacob fell in love with Rachel, so he said to Laban: “I am willing to work for you for seven years. Please marry Rachel to me.” 19 Laban said: “It’s better for her to marry you than an outsider. Stay here!” 20 Jacob worked for Laban for seven years for Rachel. Because he loved Rachel deeply, those seven years felt like just a few days to him.

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

This is actually the four core elements of an option:

Buyer: Jacob.

He is the one who wants to control the future.

Seller: Laban.

He receives benefits and promises to fulfill obligations in the future.

Underlying Asset:

The right to marry Rachel. In modern terms, this could be American bank stocks, Bitcoin, or gold.

Premium:

Seven years of free labor. To “buy this right,” Jacob must pay a price first. It’s like the insurance premium we pay—once paid, it cannot be recovered, but it provides future security.

Expiration Date:

After seven years. The specific time point when the contract’s promise is fulfilled.

What problem did Jacob solve with this contract?

He used his current labor (the premium) to lock in a future price and right, eliminating the risk that Rachel might marry someone else within these seven years. This is the most fascinating part of options:

It gives people the ability to fight against the uncertainty brought by time. The earliest DEFI explosion: counterparty risk.

What’s interesting about this story is that in the latter half, it also includes the most primitive DEFI explosion event—project teams secretly switch people.

After the seven-year period (the expiration date), Jacob was ready to exercise his right (demand to marry Rachel). But, on the wedding night, the cunning seller Laban defaulted! He secretly replaced Leah (the older daughter) with Rachel for Jacob.

The next morning, Jacob found he married Leah, and he said to Laban: “What have you done to me? I served you just for Rachel. Why did you deceive me?” 26 Laban said: “According to local customs, the younger sister cannot marry before the older. 27 After this seven-day wedding period, I will also marry Rachel to you, and you will work for me another seven years.”

This is counterparty risk—the other party to the contract is untrustworthy, causing the contract to fail to be fulfilled as promised. This is the earliest DEFI explosion.

2. Why a contract can trade the future

In Jacob’s case, he locked in a future promise with seven years of labor. Modern financial markets convert such verbal promises into standardized contracts, which are essentially strings of code in computer systems. As for why a contract can be used to trade the future, and why its price can fluctuate wildly, we can understand it through everyday behaviors like ordering a house.

Understanding the essence of options from a house deposit

Suppose someone is interested in a house worth 100k in the city center. Rumors say a metro station might be built nearby next month. If the metro station is built, the house price could soar to 15 million; if the rumor is false, the price might drop to 8 million.

The buyer lacks sufficient funds or doesn’t want to bear the risk of falling prices. So they propose: pay 100k now, which is non-refundable. In exchange, the seller provides a contract promising that within three months, regardless of how high the price rises, the buyer has the right to buy the house at 10 million.

Considering current market conditions, the seller thinks that 100k is a certain cash income. Even if the buyer gives up the purchase after three months, the house remains reserved, and the 100k is earned. This model is a standard call option trade in finance.

Why is this contract valuable?

Suppose a month later, the metro station is confirmed to start construction, and the house price jumps to 100k. The contract now becomes highly valuable. According to the contract, the buyer has the right to buy the house at 10 million, which is worth 15 million on the market. By executing the contract and reselling the house, they can net 5 million. This means the contract’s value has at least increased by 5 million.

This demonstrates two core features of options:

First, separation of rights and obligations.

Most sales contracts are two-way obligations, but options are one-way. The buyer has the right but no obligation; the seller has the obligation but no right. If the metro isn’t built and the price drops to 8 million, the buyer can simply abandon the contract, with a maximum loss of only the initial 100k premium. The buyer’s risk is limited, while potential profit remains.

Second, participation in price movements without owning the asset, creating leverage.

The buyer doesn’t actually spend 10 million to buy the house but controls the upside of 10 million worth of assets with just 100k. The profit from a 50% increase (from 10 million to 15 million) is 5 million, but with options, spending only 100k to earn 5 million yields a 50-fold return. This explains why options have high leverage—small investments can generate large gains.

3. When do people need options

Continuing from the previous question: since buyers have limited losses and unlimited gains, why are there still sellers willing to take on the potentially infinite risk? The answer lies in the different financial planning and needs of participants when facing market uncertainty.

Options markets are mainly driven by three motivations: hedging, speculation, and generating extra income.

The first is hedging, essentially buying insurance.

Suppose you hold a large amount of cryptocurrency spot assets on an exchange. You are optimistic about their long-term development but worry about short-term economic changes or regulatory policies causing a sharp market correction. Selling the spot outright would miss out on long-term gains, but holding without action risks significant asset depreciation.

At this point, you can buy a put option. This contract grants you the right to sell your assets at an agreed price at a future date. If the market crashes, your spot holdings may suffer losses, but the put option will increase in value, offsetting the decline. Conversely, if the market continues to rise, your maximum loss is just the premium paid, while your spot assets still benefit from the upside. It’s like buying downside protection for your investment portfolio at a fixed cost.

The second is speculation—using controlled leverage to amplify potential returns.

For traders who don’t want to invest large capital in buying spot assets, options offer high capital efficiency. For example, if a certain blockchain network (like the Base ecosystem) is about to undergo a major upgrade, and you expect related tokens to explode in value, directly buying the tokens requires a huge investment. But buying call options allows you to control equivalent assets with a relatively small premium, participating in the upside.

If your market judgment is correct, the value of the options could multiply several times over the spot gains; if wrong, your maximum loss is just the initial premium. Unlike futures, options buyers aren’t forced to meet margin calls or face liquidation, making them a powerful tool to define risk boundaries.

The third is generating income, which is why sellers are willing to take on obligations.

In financial markets, acting as an options seller is like running an insurance company. Most options contracts expire worthless, returning to zero. The seller’s business model is to earn premiums by taking on small probabilities of extreme risks.

Additionally, many large institutions or long-term holders use covered call strategies. If they already hold large amounts of spot assets and expect prices to stay flat or consolidate in the short term, they might sell call options. If the price doesn’t exceed the strike price at expiry, they keep the premium as extra income. During sideways markets, this approach effectively creates additional cash flow from idle assets.

These three motivations—hedging, speculation, and income—intertwine to form the options market. Hedgers seek protection, speculators seek leverage, and sellers provide liquidity and earn from time decay. Understanding these core motives allows further analysis of the four basic trading perspectives and the rights and obligations involved.

4. Call, Put, Buyer, Seller: The rights and obligations of options

Entering the options market, the most confusing part is often the four basic quadrants. But if you separate the contract types from the participant roles, the logic becomes very clear. The entire options market’s complexity is built from two types of contracts and two roles.

First, distinguish the contract types. Call options give the holder the right to buy the underlying asset at a set price in the future—think of it as a pre-order. Put options give the holder the right to sell the underlying asset at a set price—like an insurance policy or a price floor.

Next, distinguish the roles. The buyer pays the premium to acquire the rights. The buyer has absolute control and can decide whether to exercise the option at expiry. The seller receives the premium and bears the obligation. Once the buyer exercises, the seller must comply unconditionally.

Crossing these two dimensions yields the four fundamental strategies:

Long Call (Buy Call): Expectting a bullish move

The investor pays a premium (premium) and gains the right to buy the underlying at a set price in the future, with a bullish outlook.

Short Call (Sell Call): Expecting no rise

The investor sells a call, collects the premium, and bears the obligation to sell the asset at the strike if exercised. If they don’t hold the underlying (naked call), they face unlimited risk if the price surges. Usually, institutions hedge this risk with their own holdings, using covered calls to generate extra income during sideways markets.

Long Put (Buy Put): Expecting a decline or hedging

The investor pays a premium and gains the right to sell the underlying at a set price, often used when expecting a market downturn or for hedging downside risk.

Short Put (Sell Put): Expecting stability or targeting a lower entry point

The investor sells a put, collects the premium, and bears the obligation to buy the asset at the strike if exercised. For example, if an asset is at 100 and the trader believes 80 is a good entry point, they can sell a put at 80, collect the premium, and if the price stays above 80, they profit. If it drops below, they buy at 80, which aligns with their plan, and the premium reduces the effective purchase price.

These four quadrants form the foundation of all complex derivatives. Buyers exchange limited risk for leverage and choice; sellers accept extreme risk for fixed income over time.

But in real trading, the pricing isn’t just about bullish or bearish. The value of an option also involves market panic and time decay. This introduces the most core concepts in Wall Street and crypto quant models, which many advanced traders must understand.

5. From Wall Street to the crypto world: IV, Greeks, and the true core of options risk

When these sophisticated financial tools move from traditional Wall Street trading floors into the 24/7, highly volatile crypto markets, the game fundamentally changes.

In traditional stocks, investors might wait a quarter for earnings reports, and volatility is relatively predictable. But in crypto, a weekend news flash can cause 10-20% swings in Bitcoin or Ethereum. In such extreme environments, simple price guesses aren’t enough for quant arbitrage or hedging.

If you imagine standing in front of a giant blackboard trying to analyze all variables affecting contract prices, you’ll find that options pricing models are essentially multi-dimensional calculus equations. To analyze these variables, financial scientists created a system called “Greeks.”

The starting point of this system is the implied volatility (IV).

Implied Volatility: Pricing Fear and Greed

Before understanding Greeks, you must grasp IV. IV isn’t historical volatility; it’s the market’s collective expectation of future volatility.

When the market anticipates big moves (e.g., a Layer 2 network upgrade or Fed rate cut), traders rush to buy options for speculation or hedging. This rush pushes up the contract prices. We then invert this inflated price into the pricing formula to derive IV.

Simply put, IV is the fear-and-greed index of the options market. Higher IV indicates market expectation of turbulence, making options more expensive; lower IV suggests complacency, making options cheaper.

The first-level risk dashboard: Delta, Theta, Vega

With IV in mind, we can open the options risk control dashboard. The three core metrics correspond to price, time, and volatility.

Delta measures price sensitivity—directional risk. It’s defined as how much the option’s price changes when the underlying moves by 1 unit. Think of Delta as a speedometer. If your call option Delta is 0.5, then for every $1 Bitcoin rises, your option’s value increases by $0.50.

Theta measures time decay—temporal risk. Options have expiration dates, and Theta quantifies how much value they lose each day, all else equal. For buyers, Theta is like a relentless tollbooth—each day, they lose value, like holding a melting ice cube; for sellers, Theta is like daily interest income.

Vega measures volatility sensitivity—emotion risk. It shows how much the option’s price changes when implied volatility shifts by 1%. In crypto, Vega often outweighs Delta. Sometimes, you’re right about the direction, and Bitcoin rises, but if market sentiment cools and IV drops sharply, Vega losses can wipe out the gains from Delta—what Wall Street calls “vol crush.”

Advanced fine-tuning: Speed, Color, Ultima

If markets only moved based on Delta, Theta, and Vega, quant trading would be simple. But in reality, these Greeks themselves change as the market moves. To handle this, higher-order Greeks are used.

Gamma is the acceleration of Delta—how much Delta changes when the underlying moves by 1.

Speed is the rate of change of Gamma—how Gamma itself changes as the underlying continues to move. It’s like jerk in physics, crucial for managing ultra-short-term, volatile positions.

Color measures how time affects Gamma—how Gamma evolves as expiry approaches.

Ultima is the third derivative of volatility—how Vega changes when IV shifts again. It’s used mainly by institutions managing billions, performing extreme volatility curve arbitrage.

Cross-dimensional ghosts: Vanna and Charm

In modern quant research, the most fascinating are the cross-Greek interactions, especially Vanna and Charm.

Vanna measures how changes in IV affect Delta. It sounds counterintuitive: why would volatility shifts influence price sensitivity? Because when market panic (IV rising) makes deep out-of-the-money options more “possible,” the probability distribution of Delta shifts, affecting the entire portfolio. During extreme liquidations, Vanna often drives market makers to buy or sell spot aggressively to hedge risks.

Charm measures how time decay affects Delta—also called Delta decay. As time passes, an out-of-the-money option with no intrinsic value becomes less likely to turn profitable. Charm describes how Delta diminishes over time.

The true core of options risk

From basic Delta to complex Vanna, these Greeks reveal the ultimate truth: you’re never just trading a single asset dimension, but a four-dimensional space woven from price, time, volatility, and probability.

Novices often lose money on direction (misreading Delta), veterans get burned by time decay (Theta), and experts are often undone by volatility (Vega and Vanna).

Of course, writing this article isn’t just to teach hedging.

It’s to help everyone develop the ability to understand the tricks of DEFI project teams.

You want their interest,

They want your principal,

How to see through those complex structured products,

And protect yourself,

That’s the way out of a bear market.

Of course, the complexity of options can’t be fully covered in a single article.