What is Hardening
Hardening is a term used to describe commodity or futures contracts prices that are either stabilizing or advancing slowly. It is a measure of price volatility or lack thereof. Commodity prices tend to be more volatile than other investments, especially in times of equity bear markets.
BREAKING DOWN Hardening
Hardening describes a stabilization or gradual price increase in commodity or futures contracts. Volatility in commodity prices can arise for several reasons including the lack of trading volume, depressed supply due to natural disaster, or geopolitical interference. All of these factors have an impact on the basic driver of commodity prices, which is the Law of supply and demand. When availability and demand don’t equate, commodity prices fluctuate. When supply and demand align, commodity prices harden.
Commodities are basic, standardized goods which are inputs to manufactured consumer products. Well-known commodities include crude oil, corn, wheat, and precious metals. Commodities trade on a spot market, with cash settlement within a day or two, and via futures contracts. Futures allow investors to place bets on, or lock in, commodity prices, whether it be as a hedge to protect against losses due to unforeseen future volatility or as pure speculation on future price movements.
Leverage and Volatility in Futures Contracts Markets
A commonly held belief has been that the recent entry of speculators into the commodities futures markets has led to an increase in price volatility on futures contracts. On the contrary, some researchers have concluded that an influx of futures traders, and the liquidity that they bring to the market, has a stabilizing or hardening effect on futures prices. These researchers suggest that futures markets are considered volatile not because of price fluctuations, but because of a great deal of leverage available to futures traders.
- Leverage refers to the practice of using margin loans to place trades.
- Margin requirements for futures trading are much lower than for equities.
Equities margin requirements are generally 50-percent, while often 5- to 10-percent for futures contracts. Small fluctuations in the price of a highly leveraged futures contract will have great consequences and pose a potentially unlimited risk. This risk is especially harsh to the holder of short contracts who may be forced to deliver a commodity to the holder of a long contract at a significant loss. This risk is not to be confused with volatility, though. Investors in the futures market should be aware that, because traders can leverage their trades to a higher degree than in other markets, high risk can exist even under hardening price conditions when commodity prices are relatively stable.