On this episode of WaveRider Reads, we deep dives to the Darvas System. We discuss:
(00:00) Introduction to Nicholas Darvas and His Unlikely Journey
(01:02) Early Failures in the Stock Market: Gambling and Penny Stocks
(02:05) Turning to Wall Street: Learning from the Experts
(03:24) The Breaking Point: Realizing the Need for Self-Education
(04:38) Developing the Box Theory: A Systematic Approach to Trading
(05:52) Applying the Box Theory While Touring the World
(07:11) The Power of Stop Loss: Risk Management Essentials
(08:23) Isolation as a Trading Edge: Avoiding Market Noise
(09:48) Combining Technical and Fundamental Analysis for Better Trades
(11:08) The Importance of Emotional Discipline in Trading
(12:31) Trading Psychology: Handling Pressure in New York
(13:46) Big Wins: Lorillard, Diners Club, and El Bruce
(15:21) A Close Call: Trading Suspension and Market Takeovers
(16:42) Learning from Mistakes: Slipping Back into Old Habits
(18:18) Course Correction: Reinforcing Isolation and Discipline
(19:45) Applying Darvas’ Principles to Modern Markets
(20:52) Final Takeaways: Timeless Lessons for Traders Today
(21:50) Conclusion and Inspiration for Future Investors
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Introduction
The Darvas strategy is a momentum-based trading approach that focuses on buying stocks showing strong upward momentum. Nicolas Darvas developed this strategy by observing how rising stocks move in stages, consolidating within price ranges he called “boxes” before making further upward moves. The core principle is to identify these stages and enter positions as the stock breaks out to new highs.
Methodology
The Darvas methodology combines technical and fundamental analysis for stock selection and trade execution.
Stock Selection Criteria (Technical)
- Upward Momentum: Darvas looked for stocks already in an uptrend and showing strong price movement.
- Price Action and Volume: He noted daily stock quotations, paying attention to highs, lows, and volume spikes. He used volume surges as a sign of strength.
- Darvas Boxes: A stock consolidates within a price range before its next move. The high of the previous move becomes the top of the new box.
- Breakouts to New Highs: The primary buy signal occurs when a stock breaks above the top of a Darvas Box into new all-time highs, preferably with increased volume.
- Stable Price Base: Stocks with a stable price base over several weeks before breaking out were preferred.
- Moving Averages (Modern Application): While not used by Darvas, modern traders incorporate 5-day EMA, 10-day SMA, 50-day MA, and 200-day MA as additional support and breakout indicators.
Stock Selection Criteria (Fundamental)
- Growth Stocks: Darvas targeted high-growth companies in emerging industries like electronics and rocket fuels.
- Overall Market Uptrend: The general market cycle influences most stocks. Darvas focused on bull markets.
- Alignment of Fundamentals and Price Action: Stock price action should align with earnings growth and fundamental strength.
- Techno-Fundamentalist Approach: Stocks were chosen technically, but purchases were made only if fundamental earnings growth was evident.
When Does This Strategy Work Best?
The Darvas strategy performs best in strongly trending bull markets, where stocks experience sustained upward momentum. It also thrives in rapidly expanding industries with high-growth potential.
Less Effective Conditions:
- Bear Markets: Stocks struggle to break out, and the risk of failed breakouts is higher.
- High Volatility Periods: Market turbulence may cause whipsaws and false breakouts.
Entry Strategy
Key entry points for the Darvas strategy include:
✅ Breakout to New All-Time Highs: The price moves above the upper limit of a Darvas Box, ideally with rising volume.
✅ Bounce at the Bottom of a Darvas Box: Some traders buy when the price bounces off support at the bottom of the box.
✅ Breakouts and Bounces at Moving Averages:
- Bouncing off the 50-day moving average.
- Breaking above the 50-day moving average.
- Bouncing off the 200-day moving average.
- Breaking back above the 200-day moving average after a bear market.
✅ Finding Support at the 5-Day EMA or 10-Day SMA: Short-term support signals in strong uptrends.
✅ Pilot Buy: Darvas often initiated a small “pilot buy” before committing larger capital.
Exit Strategy
Darvas had a disciplined exit strategy to protect profits and limit losses.
🚨 Breaking Below the Darvas Box: If a stock falls below the lower edge of the box, he would sell immediately.
🚨 Trailing Stop-Loss Hit: He used a trailing stop-loss that moved up with the stock price, locking in profits while letting winners run.
🚨 Initial Stop-Loss Order Hit: Every buy had an automatic stop-loss order to limit potential losses.
Risk Management
Darvas’ risk management principles were key to his success:
🔹 Always Use Stop-Loss Orders: Stop-losses were placed at the time of purchase to define risk upfront.
🔹 Trailing Stop-Loss for Profit Protection: This ensured gains were locked in while allowing stocks to run higher.
🔹 Pilot Buys for Testing Trades: Small initial positions helped confirm a stock’s trend before committing more capital.
🔹 Never Add to a Losing Trade: Darvas only added to positions showing a profit.
🔹 Emotion-Free Trading: He focused purely on price action, avoiding emotional attachment to stocks.
🔹 Liquidity Matters: He only traded listed stocks, ensuring easy exits when needed.
🔹 Spreading Trades Among Brokers: To avoid detection, Darvas sometimes used multiple brokers.
Conclusion
The Darvas strategy is a momentum-based approach that capitalizes on breakouts to new highs while employing strict risk management rules. It works best in bull markets and high-growth industries. By combining technical signals and fundamental growth analysis, traders can ride powerful trends while limiting downside risks.
🔹 Best Suited For: Trending bull markets, strong growth stocks, and disciplined traders.
🔹 Not Effective In: Bear markets, high-volatility sideways markets.