Dear Partners,

October has been a month of challenges and careful recalibration for our fund. Reflecting on this period, we faced leverage concerns and overtrading issues that tested the resilience of our strategy and brought valuable lessons about liquidity, risk management, and prudence. These experiences echo the words of renowned hedge fund manager Paul Tudor Jones, who cautioned against the dangers of leverage. His insights highlight that leverage, while a powerful tool for amplifying gains, can quickly become a risk if it forces a portfolio into unwanted selling during volatile market conditions.

As Jones emphasized, the main danger of leverage lies in its potential to compel rapid, sometimes unfavorable selling when a portfolio’s capital is stretched thin. His words serve as a powerful reminder that even seasoned managers can find themselves at the mercy of leverage. Reflecting on this, I was reminded of the saying from the Czech Republic: “Fire can be a good servant but a very bad master.” The same is true for leverage. If managed correctly, leverage can serve us well; when overused, it risks taking control of our portfolio.
 

Recognizing the Risk and Course Correction

 
This October, when the market’s volatility surged, and margin calls intensified, we had to face the reality that our use of buying power needed reassessment. Futures options differ from options on stocks or indices in that their buying power requirements fluctuate more frequently, often being marked to market daily. While I initially took the temporary release of buying power as an opportunity to add new positions, this led to a momentary strain on our account when that same BP was swept back unexpectedly due to increased volatility. This experience underscored the need for disciplined BP management, particularly with futures options.

However, a few prudent measures helped us navigate through this volatility. By maintaining cash reserves, we were able to satisfy margin calls without forced liquidations. Recognizing the potential risk early enough allowed us to take immediate steps to stabilize the portfolio.
 

High Volatility’s Role in Portfolio Stress

 
Some of the current portfolio stress has been driven by the unusually high volatility in the market, with certain indicators spiking to levels around 76%. This extreme volatility has been fueled by factors including the election cycle and broader economic uncertainties. While this heightened volatility places temporary strain on the portfolio, we anticipate that stress to ease as volatility declines, particularly after the election. If the election outcome is smooth and uncontested, we expect a decline in market volatility, which would provide relief to our portfolio. However, should the election results be contested, this high volatility—and, with it, portfolio stress—may continue or even intensify in the short term.
 

Implementing New Safeguards

 
As part of our course correction, we established new rules for trade entries. These measures are designed to prevent overexposure and include maintaining a set minimum BP, capping the number of open trades, and ensuring a minimum level of cash reserves. These reserves serve as a buffer to provide flexibility if we encounter heightened volatility, and if used, they are to be rebuilt promptly.

Additionally, we halted redemptions and distributions temporarily to protect the portfolio’s integrity during this period of recalibration. I’m encouraged to report that these adjustments have proven effective. Our buying power is gradually increasing, cash reserves are rebuilding, and our trade count is being managed within set limits. With these risk parameters now in place, we have resumed distributions and redemptions, albeit with continued caution.
 

A Path Forward

 
While we’re not entirely out of the woods, the portfolio is in a much stronger position. October’s events have underscored the value of liquidity and conservative leverage management. Our portfolio has shown resilience under market pressure, with improvements in BP and cash flow. This period has reinforced our approach to mindful trading, and I am confident these adjustments will support long-term stability.

Thank you for your patience and continued trust as we work to create a more robust and resilient portfolio.

With regards,
 

Martin Zourek
Managing Director,
ZZ Capital Management, LLC