Forwards and Options.

The following can be a way to look at derivative instruments and claim its understanding. In case you are a farmer who has to sell rice and is constantly worried about the price fluctuations, you can protect yourself from the falling prices by selling a forward contract which will ensure that you will get an assured price for the volume of rice sold. This is a way where the price risk is negotiated for your commodity.

While the forward allows the farmer to be protected against the losses in case the price of rice falls, he is however giving up the opportunity of making profit if the price of rice increases. Thus he needs an insurance against falling rice prices. The farmer buys a put option wherein if the price of rice falls below the agreed price (strike/exercise) then the seller of put option will pay the difference between the agreed price and fallen price. If the price of rice increases above the strike price then the farmer benefits from the price rise. Thus the farmer is protected from the losses of price fall and benefits from the price rise all by paying a premium fee for this kind of price insurance.