Where you are. Lesson 3 called the deposit “the cushion” and admitted it was doing two jobs at once. This lesson separates them. The distinction is the single most useful thing in the module’s second half, and once you have it, every collateral arrangement in finance reads the same way.
The loss that has happened, and the one that has not
You are long sixty contracts. Today the price falls a point, so you have lost sixty. That is not a possibility or a projection; it happened, and somebody on the other side is up sixty and would like it.
Tomorrow the price might fall another two points, or five, or ten. That has not happened, and nobody knows if it will.
Those are two completely different quantities and they need two completely different treatments. The first should be paid, today, because it is a realised fact. The second should be secured against, because it is a risk. Confusing them is how a position accumulates an unpaid loss until it is too large for anybody to pay.
The idea in one paragraph
Margin comes in two kinds doing two jobs. Variation margin settles the profit or loss that has actually occurred, paid daily in cash from the losing side to the winning side, so that no unpaid loss accumulates overnight. Initial margin is a buffer posted at the start and held throughout, sized to cover a plausible adverse move over the time it would take to close the position out if you stopped paying. Variation margin is a settlement; initial margin is a security deposit. A margin call is the demand that the balance be restored when it has fallen below a maintenance level, and it is a demand for a specific amount by a specific time, not a conversation.
Thirty days, and two calls
The exercise runs a seeded price path for a month against a sixty-contract position, with an initial margin of a thousand and a maintenance level of seven hundred.
The path falls from 100 to about 87.46 - a genuine downtrend, not a crash. Variation margin is paid daily as the losses occur, and twice the balance falls below maintenance and a call restores it to the full initial level.
The assertion worth noticing is the last one: the net of everything paid and received over the cycle equals the whole price move times the position size, exactly. No part of the loss was deferred, negotiated or forgotten. It was collected as it happened.
Why the maintenance level sits above zero
The call comes when the balance falls below maintenance, which is set above zero deliberately - in the exercise, at seven tenths of the initial amount.
If the call waited for the balance to reach zero, the demand would arrive at the exact moment there was nothing left to demand it from, and the close-out would happen with no cushion for the price to move during it. The gap between maintenance and zero is the time and room the clearing house needs to act.
This is the same design as lesson 3’s liquidation trigger and module 4’s collateral cushion. Every one of them is the same idea: act while there is still something to act with.
What the winning side gets
Variation margin is not held by the clearing house; it is passed through to the party that gained. That is why the exercise tracks both paid and received, and why the two sides of every cleared market are settling with each other daily through the middle.
That daily transfer is what makes lesson 14’s clearing house possible. If losses were allowed to accumulate until expiry, a defaulting member could owe an unbounded amount. Because they are settled daily, the most anyone can owe when they fail is one day’s move - which is exactly the quantity initial margin was sized to cover.
Check yourself
1. What is the difference between the two kinds of margin, in one sentence each?
Variation margin settles the profit or loss that has actually occurred, paid daily so nothing accumulates. Initial margin is a buffer held throughout against a plausible future move, sized to cover the time it would take to close the position if payments stopped.
2. Why is the maintenance level set above zero rather than at it?
Because a call at zero arrives when there is nothing left to collect and no cushion to close the position into. The gap between maintenance and zero is the room and the time needed to act while the outcome can still be contained.
3. Over the thirty days, the net of margin paid and received equals the full price move times the position size. Why does that matter?
Because it proves nothing was deferred. Every day’s loss was collected on the day it occurred, so no unpaid exposure built up over the month. That is precisely the property that limits what a defaulting party can owe.
4. A firm is fully current on variation margin and still fails when volatility spikes. What happened?
The model sizing initial margin demanded a much larger buffer, and the firm could not produce that much collateral at short notice. The two margins protect against different things and fail in different ways, and initial-margin calls are procyclical: they ask for the most cash exactly when cash is scarcest.
Do this
Run the cycle and watch the calls land.
python3 code/margin_cycle.pyThe starter leaves you the daily step: apply the day’s move to the balance, track it as paid or received, and when the balance falls below maintenance, count a call and restore it to the initial level. The assertions check that this seeded path calls exactly twice, that the balance is restored after each, and that the net of everything paid and received equals the entire price move. Success prints the cycle summary and the line noting that the loss was collected daily rather than allowed to accumulate.
The completed version is in solutions/margin_cycle.py.
What you can now do. You can run a margin cycle, name what each kind of margin protects against, and say why the maintenance level sits where it does. The next lesson follows the collateral itself and finds that it does not sit still.