The Nicolas Darvas Trading System

What is the Darvas System and how has it evolved since being introduced 50 years ago?

Nicolas Darvas, the Father of the Darvas Trading System.In a nutshell, the Darvas System is a trend-trading system created by Nicolas Darvas in the late 1950s.  Today, top traders use it to find the market’s fastest-moving growth stocks and ride their trends to profits.  

The Darvas System is NOT just a technical “boxing” system and it is  NOT a day trading strategy.  

While a Darvas trader will always cut his losses quickly, most winning trades are held for a period of several weeks or months.

The goal of Nicolas Darvas’ system was to invest only in stocks with the potential to double, triple, or quadruple over the next six to 12 months.  He developed a list of criteria which he found to be most indicative of the potential he was looking for.  

Without a doubt, Darvas’ criteria worked as he turned $30,000 into more than $2 million in less than two years by applying this strategy.

The Darvas Trading System in Darvas’ Own Words

In his final book published in 1977, You Can Still Make It in the Market, Darvas tried to clarify what his system entailed. The following characteristics are presented in their order of importance according to Darvas:

1- Only buy companies “whose growth and earnings prospects look highly promising.”

2- Avoid companies that are “already so big that the prospect of any further substantial growth is highly unlikely.”

3- “Check the overall market trend to ascertain whether stocks in general are in an uptrend.”

4- “Check whether the stock belongs to a strong industry group, i.e., a group that is performing well in the market relative to other groups.”

5- Consider the stock only “if it is rising in price on high volume.”

Then, and only after passing these first five requirements, would Darvas evaluate a stock in light of his “Box Theory.” 

The Darvas Box Theory

How does Darvas describe his Box Theory? Simply stated, Darvas writes that stock price movements are not erratic and random, but rather, “a series of price ranges or boxes.”

Notice here that Darvas explains his theory as a series of price ranges OR boxes, thus implying that the Darvas Boxes shouldn’t be applied too rigidly. 

A lot of work goes into properly defining these Darvas Boxes, but for now, simply understand that Darvas was looking for stocks that developed recognizable price ranges – areas of support and resistance.  And, he wanted to see these price ranges trending higher and higher – in other words, he wanted to see higher highs and higher lows.

That is the Darvas System in its simplest terms. 

Wall Street likes to call this style “trend trading” because you buy high-growth stocks as they move up in price (trending higher) and only sell them when the stock falls below previous support levels (breaking a trend). 

Big institutions – mutual funds, hedge funds, pension funds, trust funds, etc. – have the ability to drive stock prices quickly and as a Darvas System trend trader, you’re basically following the trend created by these institutional moves.

The Individual Trader’s Advantage 

This is why an individual trader has a huge advantage over a large institutional fund manager.  Because of their size, institutions are unable to get in and out of positions quickly, but an individual trader has this capability. 

An individual can ride the trend on the way up and easily get out before the institutions have time to unload their huge positions.  This is also why it can be difficult to achieve huge returns with the Darvas System once you’re dealing with an account of more than $50 million.  (Of course, having an account that large would be a good problem to have for most individual traders.)

Some of you may be noticing the many similarities between the Darvas System and William J. O’Neil’s popular CAN SLIM system.  O’Neil was heavily influenced by Darvas’ teachings, so this is no accident. 

However, while O’Neil is a brilliant trader who has helped thousands make better investment decisions, I feel that there are some aspects of the CAN SLIM system that, frankly, aren’t all that important in picking winning stocks. 

Therefore, we offer a new, easy-to-remember acronym for the Darvas System:

D – Direction of the Market
A – Accelerated Earnings and Sales
R – Relative Price Strength (and Return on Equity)
V – Volume Increasing
A – Aggressive Growth Group
S – Sound Base Pattern

To further explain:

D – Direction of the Market 

Is the market, as a whole, in an uptrend?  It is highly unlikely that a stock will have huge gains when the overall market is in a downtrend, so make sure the direction of the market is moving upward.

A – Accelerated Earnings and Sales

Is the company seeing increases in earnings and sales this quarter compared to the same quarter last year? 

Normally, you want to see stocks with at least 40% increases in earning AND sales in the most recent quarter compared to the same quarter last year.  And remember, the higher the increase in earnings and sales, the better.  If you have a choice between a stock with a 50% increase and one with a 90% increase, definitely go with the 90% increase stock.

R – Relative Price Strength (and Return on Equity)

Is the stock outperforming most other stocks in terms of its price increase? 

Darvas wanted to see stocks that had at least doubled over the past year before he’d consider buying.  If a stock has already increased a great deal over the past year, most investors are fearful of a steep decline, but many studies have shown that Darvas was right in his assessment; if a stock had already made a powerful move, it proved that it had the ability to move in such a fashion and therefore, was likely to do it again.

Another important characteristic of ideal Darvas stocks is a high Return on Equity.  Fund managers love to see a high ROE.  Some put a higher value on ROE than they do earnings and sales. 

William O’Neil conducted a 50-year study on top performing stocks.  This study’s findings were published in his classic book How to Make Money in Stocks.  O’Neil found that almost all of what he labeled “the greatest growth stocks of the past years” began their runs with a Return on Equity of 17% or higher.  And just like when it comes to earnings and sales, the higher the ROE is, the better outlook for the stock.

Therefore, with the exception of rare cases when earnings or other conditions are extremely attractive, we should primarily buy stocks with a ROE of 17% of higher.

V – Volume Increasing

Is volume increasing on up days, particularly on the day when the stock breaks into new highs? 

Volume can tell you so much about a stock.  Ideally, you want to see much higher-than-normal volume when a stock breaks into new highs and lower volume when the stock declines.

A – Aggressive Growth Group

Is the stock a member of an industry group that has been increasing in price more rapidly than most other groups? 

At any given time in the market, there are certain groups and sectors that are very hot.  It’s always been this way and always will be this way.  Make sure your stocks are members of these hot groups.

S – Sound Base Pattern

Is the stock breaking out of a sound base pattern? 

If a stock meets all of the above criteria, it is potentially a huge winner. 

Remember, as Darvas said, the only reason to buy a stock is if this price of that stock is going up.  He was only interested in stocks that could double, triple, or quadruple over the next six to 12 months. 

If you concentrate your stock selections to these types of stocks, you too may soon join the growing list of Darvas Millionaires. 

Unfortunately, most traders lack the discipline to stick with these strict requirements.

by Darrin J. Donnelly
Editor of DarvasTrader.com

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