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Tuesday, September 11, 2012

Nicolas Darvas trading system

"There are no good or bad stocks, there are only rising and falling stocks" by Nicolas Darvas.

In my humble opinion anyone who wants to make money trading has to learn from those who have already done that. There are a lot of books written on successful trading. However, most authors have not made any money in the market. They simply write about those who managed to do so by trying to analyze their methods or they present strategies and systems that they believe to be working. When you pick up a book and start reading after a while you will start feeling whether the author himself trades or not. If he does not he will only be sharing theory with you. You need more than that. You should listen to those who made it. Let them be your mentors. Read their books and learn their trading style. Try to understand what made them successful and then by imitating them try to find your own unique trading style. I am intending to start a series of articles about some of the most successful traders and they way they made millions in financial markets. I hope you will benefit from these. Today’s topic is Nicolas Darvas trading system. 

Having finished reading you might apply his strategy on eToro social trading platform, the favorite among thousands of traders.  

How it all began

Nicolas Darvas was a professional dancer (anyone can do it) who came to trade stocks by accident. At some point in his career he got an unusual offer. People who invited him to perform offered to pay him in stocks (Brilund). To cut the long story short he purchased those shares from them (6000) for the amount of 50 cents per share. He then forgot completely about them. One day when he looked in the newspaper he saw the quote of the stock was 1.90 dollar per share. He immediately sold his holdings and made a profit of over 8000 dollars. 

He immediately understood that he was missing something great in his life and started taking active interest in stocks. Nicolas undergone all the usual stages any newbie trader goes through when he starts trading: seeking tips from anyone: both amateurs and professionals, subscribing to various financial newsletters, asking advice from his brokers, buying a lot of stocks and selling them fast. These things made him lose half of his (Brilund) profits.

Darvas decided to become a fundamentalist and started looking at company’s ratings, share price, price earnings ratio, earnings per share, dividends and etc. He would try to find the best industry and the best stock in the industry. At some point he thought he got it and selected the best industry with the best stock in that just to find out how wrong he was. He pledged his property in order to buy the stock. This operation caused him to lose 9000 dollars. 

He was desperate to lose his property in Las Vegas and desperately started searching for a stock that could save him. He noticed one that was climbing (Texas gulf) at the time and decided to put all his money in it just because the stock was rising. He recouped half of his losses and got out of the stock.

His findings

 All fundamental stuff did not help him, but caused only losses. On the other hand not knowing anything about the stock but jumping into it because it was rising made him money. He said:” The stock that saved me from disaster was one about which I knew nothing. I picked it for one reason only— it seemed to be rising.“

Darvas decided not to base his trading on luck anymore. He decided to repeat the process that he did with (Texas gulf) and he succeeded again. He found a stock that was rising “m & m wood working“ and bought it. He made some nice cash. He could not find much information about it, but it worked again. 

His criteria for selecting stocks

If an inactive stock would suddenly begin to rise (with nice volume) that meant something and he should get ready to jump into the stock. 

Box theory

How to judge a movement at the time it happens? Is it right time for entering market or it is time to stay away, or maybe close a position? He went on to study patterns of stock fluctuations and see if there are some tendencies. He says that: „Stocks did not fly like balloons in any direction. As if attracted by a magnet, they had a defined upward or downward trend, which, once established, tended to continue. Within this trend stocks moved in a series of frames, or what I began to call "boxes" They would oscillate fairly consistently between a low and a high point. The area, which enclosed this up-and-down movement, represented the box or frame.

He expected the stock to bounce between the upper and lower part of the box (range). If it didn‘t he would leave the stock alone. He wanted the stock to be alive. If it wasn‘t, even if it broke out it would probably not be able to move dramatically. 

The stock could stay in the box (let‘s say 30-35) for a long time. As long as it did not move below that level Nicolas was fine with that. If it, however, did move below he would stop watching the stock. For him, it meant there was something wrong with the stock and the trend of it was down. He wanted only those stocks that had potential to go up. 

So, if the stocked bumped between 30-35 he would continue watching. If, however, it started going above 35 he would buy the stock. We know it as a breakout trade. He started using a breakout trading strategy. When a stock went above the price box he would buy it. 

His stop loss theory

 He saw that his theory did not work 100 percent and the natural thing that he did was to limit risks. So, if he bought a stock climbing to another „higher box“ (let‘s say from 30-35 to 36-40) at 36 and suddenly the stock would start falling back into previous box of 35-30, he would sell it at 1 point loss (his stop being at 35). This is how he limited losses. If stock acted right (climbed bit by bit higher (with some fluctuations) he would let his profits increase. 

At this point he developed this formula for trading his strategy:

1. Right stocks
2. Right timing
3. Small losses
4. Big profits

It was interesting that Nicolas Darvas was trading at the time online trading was non-existent. Once he shaped his trading strategy he set up a two year tour around the world with his dancing act. He was afraid that it would limit his possibilities to trade in stocks. However, on the contrary It turned out to be an advantage rather than disadvantage. He would not need to check his stocks every fifteen minutes, but concentrate on those that were active and moving. His broker would regularly send him telegraphs and he would also get Barton’s magazine with quotes of various stocks. 

Techno fundamental theory

Nicolas Darvas made another fundamental discovery. Although, his fundamental analysis did not really work he noticed during a major bear market some stocks tend to resist downward trend than others. He found out that these were stocks that had good earning trends. Seeing that he made a conclusion that:”stocks are slaves of earning power”. Therefore, in terms of fundamental analysis he decided to follow only earning results of companies he was interested in.  He blended his technical approach to the market with this specific fundamental aspect and got tremendous results in trading. 

The same approach works today. You just analyze stocks and what happens with them when they reach important support levels and quarterly earnings reports are released. Select the best companies wait for them to reach support and wait for earning season to come. Just these two things will make you a profitable trader.
The same thing can be applied to trading currencies. From fundamental point of view you will be looking at interest rates releases (not earnings) and the same support/resistance issues. It does not mean you will never fail. It means you will have much bigger profits than losses trading this way.

This kind of trading made Darvas to make over 2 million dollars in stocks. He did it by trend trading. Here is a chart of his most successful operation at the time. 

Travelling around the world and using his techno fundamental approach Nicolas Darvas was able to make around two million dollars of profits. However, like any other trader he had his own weaknesses and this was revealed when he came back after the tour around the world and got closer to Wall Street. There he was surrounded by rumors, tipsters, news, opinions, brokers and other losers. In this type of crowd he could not but give in to crowd mentality and abandoned his trading rules by trying to go with the crowd. In a matter of two weeks he lost around 100 thousand dollars. 

It is good lesson for us too. We should stop listening to tips and develop our own trading style and system. Then we should follow it faithfully. You can never follow a crowd and expect to make money in the markets. The crowd is almost always wrong. 

If you liked the post I would also be happy if you added it on Google+, tweeted, liked it on Facebook and other social platforms. Have a nice day. 

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Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.