When I talk to people about my credit spread trading strategy I often hear the claim that credit spread trading works great for 5, 10, or 20 thousand dollars, but the strategy can’t be scaled up. Are these skeptics suggesting a lack of liquidity to fill bigger orders? Or that trades in the 100 thousand range have the power to move markets? Bunkum. When trading an underlying such as the SPY or SPX there is plenty of liquidity. And you most likely need to be trading an account over 100 million before liquidity and put credit spreads are issues.
Maybe my friends are suggesting something else when they say my credit spread trading strategy doesn’t scale. If you are only trading a $25,000 account an annual return of 40% or more is fairly common. Returning 40% on a $200,000 account is more difficult—but not because of market mechanics. It’s more difficult because of the emotional risk involved. If something goes wrong and you lose most of your $25,000 account it’s not the end of the world. Blowing up your $200,000 account hurts a lot more, and it might take many years to recoup such a big loss.
Bankroll management conventional wisdom suggests that you risk less per trade as your account gets bigger—both to defend against emotional risk and to protect your nest egg. And small trades on a big account yield a lower return rate than the same number of winning big trades on a small account.
Scaling Via Overflow
I like to trade many multiple strategies so I think about scaling all of my strategies as a whole. I call this the overflow method. Imagine 3 buckets mounted above each other. The top bucket is small, the middle bucket is bigger, and the bottom bucket is the biggest. If you fill the top bucket with water it will eventually overflow and fill the bucket below it, which will likewise overflow and fill the biggest bucket on the the bottom.
Now, replace those buckets with your trading and investing strategies and the water with the money in your accounts. Let's assume the smallest strategy is day trading (buying and selling on a single day) and the account has $10,000. The midsize strategy might be put credit spread trading with an account of $50,000, and the granddaddy strategy is buy and hold with an account of $500,000. As the accounts grow your profits overflow to the next bigger account and less risky strategy.
Why Does the Overflow Method Scale?
In other words, with the overflow method you scale by channeling capital from your smallest, most risky accounts to your biggest, least risk-affected account. The key is making sure the account size matches the risk you put on it. Smaller accounts can take on more risk, and bigger accounts should take on less. Done right, the overflow method ensures that all of your accounts grow. Some day I hope my put credit spread account is trading many millions of dollars, but for that to happen my buy and hold (least risky) account will have to be almost 10 times that. My strategies scale based on risk.