NICOLAS DARVAS

 

This article presents the story of a legend trader who was once a newbie. He was absolutely unfamiliar with the markets on day one but in almost 6 years he built a fortune for himself. He had to face many difficulties and failures but he never gave up. Through his passion and zeal for trading he devised some unique methods to trade stocks. His story would surely enlighten many budding traders and encourage them to follow a disciplined approach towards trading.

A Dancer’s Pay-out

On a very fine day in November 1952, when Darvas was giving a dance performance with his partner Julia at the Latin Square in Manhattan, his agent telephoned him and told about an offer. Al and Harry Smith, also called Smith brothers, offered him 6000 shares of Brilund Company for his performance in Toronto. The share was trading at 50 cents at that time. Smith brothers also promised him to compensate for the next 6 months if the price of the share falls below 50 cents. It was an unusual pay-out offer for a dancer but Darvas accepted it. Unfortunately, he could not get to perform that day. As a good gesture, he sent a $3000 cheque to the Smith brothers for buying 6000 shares they had offered. He received the shares but never tracked them as he was least interested in the markets. After two months he came to know that Brilund’s price went up from 50cents to $1.90. He got very excited and sold the shares immediately for a profit of about $8000. This investment grew his capital to $11000. After this trade Darvas got so fascinated by the stock market that he made his mind for this business.

The Grasshopper Gambler

Darvas was very excited but he knew nothing about the markets. He continuously searched for a good broker and stock tips which could make him a fortune. He relied upon hunches from brokers, friends and whisperers for stock selection. But most of his trades (like trades in Eastern Malartic, Mogul Mines, Quebec Smelting etc.) made him nothing but losses. He used to overtrade keeping small quantities of 25 to 30 stocks at one time. And if he is getting 2 points from a trade, he will get out. At first he could not realize that commissions and transfer fees are eating up his capital faster than his losses. Due to the same reason, even small trades of just 1-2 points were actually making him loss. He kept on jumping from one trade to the other overlooking his losses and feeling happy about small profits. After gambling for about 7 months he realized that he lost around $3000. He took professional help from a financial advisor but that could not make him profitable. In the next seven months he was left with only $5800 out of $11000.

At this point his biggest problem was lack of knowledge about the markets. He had no strategy on what to buy, when to buy and when to sell. So he was taking small profits and big losses. This problem is very common with any new trader. Let’s see how Darvas solved this problem.

Fundamentals That Did Not Work

Darvas took some more money from his savings and raised his trading capital to $10000 before entering the Wall Street. This time he decided to alter his strategy from hunch trading. He got introduced to what he calls ‘information’ about the fundamentals of the stocks. He made a series of small profits in fundamentally sound companies but these trades could not bring him fortune. Still a lot of money was draining in the form of brokerage and transaction charges. He was heavily relying upon the ‘information’ that he received from professional financial advisors. Due to frequent trading he was still less than a breakeven trader and it is evident from his own words.

“If I had stuck with KAISER from my original purchase at 63 3/8 until my ultimate sale at 81 3/4, I would have had a profit of $1748.75 instead of the loss of $461.21”

By 1955, through his experience in a large number of trades he outlined certain rules:

1.      Do not follow an advisory service;

2.     Be cautious with broker’s advice;

3.     Ignore all Wall Street sayings;

4.     Always trade in listed stocks where there is always a buyer present;

5.     Do not listen to the rumours;

6.     It’s better to study fundamental approach which worked better than gambling;

7.      Hold on to a rising stock for longer period than juggle with a dozen stocks for a short period of time.

After applying all the knowledge about fundamental analysis, that he gained from reading books, he bought 1000 shares of Jones & Laughlin at 52 1/4 in September 1955. He was so confident with his knowledge discovery that he mortgaged his property; took loan on his insurance policy; and borrowed advances to purchase this stock. The cost was $52,652.30. Sadly, after three days the stock began to drop. In October he had to sell the stock at $9,069.18 loss. He felt crushed because this time he did not gambled. He bought because there were fundamental reasons behind it.

Although this trade was destructive yet he did not give up and kept on looking for his next trade. This time he saw Texas Gulf Producing. Neither he knew anything about the fundamentals of this stock nor there was any news. All he knew was that this stock was rising. He bought 1000 shares at around $37 and it went up to $40. For the first time in his life he decided to hold for longer period of time as he had to cover his $9000 loss. After holding for about 5 weeks he sold it for $43 1/4 which recovered almost half of his loss in J&L.

Darvas tried to improvise with fundamental analysis but still he suffered from risk management as he oversized his positions and took too much risk on a single trade. One thing that he learnt from Texas Gulf trade was that he should learn to hold a rising stock but he did not know when he should get out of a rising stock. His later discovery answered his questions.

The Box Theory

After the Texas Gulf trade, he came across the technical approach to trading. He bought that stock just because it was rising. He further tried to solidify his approach by observing volumes in the stocks. He noticed that if a stock is rising on good volume or an increasing volume, there were greater chances to make money in it. He also realized that timing is equally important. Buying a good stock at wrong time will only be disastrous. He observed that all stocks trend up or down in a series of ‘boxes’. In his words,

“They (stocks) 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. These boxes began to exist very clearly for me. This was the beginning of the Box theory which was to lead to a fortune.”

He found that these boxes sit on top of each other in an uptrend and the right time to enter was when the stock enters to the next higher box.

He devised some more rules for himself:

1. Markets are not certain. One could be wrong 50% of the time;

2. One needs to overcome ego in order to readjust to the facts;

3. One needs to be impartial as far as stocks are concerned;

4. One needs to work on reducing the risk.

He learnt to put Stop-loss orders to reduce the risk. In order to rectify the problem of selling too early, he disciplined himself with raising the stop losses as the stock went higher. He would take profit if his trailing stop loss is hit or the Boxes start to reverse.

He clearly defined his objectives — “Right stocks; Right timing; Small losses; and Big profits”

His tools were — “Price and Volume; Box theory; Automatic buy order; and Stop-loss sell order”

Losses Would Kill Your Ego

Darvas decided to tour around the world for two years for his dance performances. But at the same time he did not want to lose trading. So he patched up with his broker to send him telegrams that would quote the stocks he owned. Also he arranged “Barron”, a weekly financial publication, that would be air mailed to him. He would get these two things where ever he goes. He used to receive Barron four days after the publication. He looked for stocks that met his criteria and telegram his broker to ask for the stock’s movement for the week. Darvas went to many countries for his performance. He also came to India for his performances in Calcutta and Delhi.

It was difficult for him but he managed to learn how to find stocks from the magazine and trade through cables. He also learnt a new thing that is, to train his emotions. For that he used to maintain his trading journal. He would note the reason for buying a stock; reason to take profit; reason for taking a loss; find the mistakes; and not to repeat those mistakes again. This way he learnt something from each trade.

He learnt to supress his ego and it is clear from his words,

“My educated guesses, no matter how cautious they were, many times turned out to be wrong. But this did not upset me anymore. After all, I thought, who was I to say what a stock should or should not do.”

Suddenly in August 1957, his trailing stop loss system threw him out of all stocks but one. He sat on cash as he searched for stocks that would meet his criteria but none matched. That happened several months before it was finally declared that a bear market has started. His stop-loss system saved him a lot a money. By the second half of 1957 he had an overall net loss of $889 in his account.

Darvas started believing that stop loss was his best weapon.

A Techno-Fundamentalist in India

With no stocks in his portfolio he started looking for opportunities in sectors like electronics, missiles, rocket fuels, fashion etc. which will have robust growth aspects for the next 20 years. Within such stocks he tried to filter those which posted good earnings. Beside these fundamental factors he selected those stocks which had relative strength in the bear market. Means the stocks which had lesser fall compared to the index averages. Finally, he found a few stocks like Universal Products, Thiokol Chemicals, Texas instruments, Zenith Radio, Fairchild Camera. These were the stocks which started to recover, even when the index averages were still falling.

In November 1957, he came across another stock that met his buying criteria. It was Lorillard, a cigarette company, trading in a narrow box of 24-27. He bought 200 shares at 27 ½, as the stock came out it’s range, with stop loss at 26. The stock hit his stop loss and immediately went back up. Noticing the short lived reaction, he again bought this stock at 28 3/4 with stop loss at 26. This time the stock went up to a new box of 31-35. He bought 400 more shares at 36 1/2 as it came out of this box. The stock went up to 44 3/8 when a bad news came in the market. The stock plummeted to 36 3/4 in a single day. Darvas immediately raised the stop loss to 36, which was never touched. Now he had 1000 shares of Lorillard and he kept on raising his stop loss (his best weapon).

He also bought Diner’s Club (bought at 26 1/8 and sold 57 3/8), Bruce (bought at 50 3/4 and sold at 171). He made $2,95,305.45 from Bruce on his trip through India.

After these trades Darvas was very disciplined with his stop losses. He would buy rising and fundamentally sound stocks; add more quantity as the stock moves into a higher box; raise his stop loss as the stock trend up and finally take profits. During his journey to Calcutta, Delhi, Karachi, Paris etc. and then back to New York, his investments made him $500,000.

Too Much Noise May Scrape Your Ears

After making this much money Darvas was filled with over confidence. He decided to trade on-the-spot dealings that is, day trading. Soon he was taken over by the electrifying environment of the broker’s office and started forgetting what he had learnt in the past. He himself mentioned,

“I bought stocks at 55. They went back to 51. I hung on. Stop-loss? That was the first thing I threw away. Patience? Judgement? I had none. Boxes? I forgot about them.”

Eventually he lost $100,000 in a few weeks. It was a devastating experience for him. After deeper thinking he realized that he was dealing with too much information around him. His ears were listening to rumours, contradictory information, there were panics and interruptions. He decided to move away from the NY Exchange, so he took a plane to Paris where he recollected himself.

All’s Well That Ends Well

After returning back to New York in Feb 1959, the first thing that he did was to isolate himself from the live markets. No telephone calls during the day. His work started at 7p.m. when the market is closed. He would analyse his telegram messages along with a piece of newspaper with Wall Street closing prices on it. Any contingency during the day would be met by his stop-loss orders that his broker was instructed to place. May be by this time he would have learnt that he is good at swing trading and day trading is not his cup of tea.

He religiously followed his principles and his profits started to outperform his losses. After a few good trades like Texas Instruments (5500 shares), Thiokol (6000 shares later turned into 18000 after 1:3 split) his profit grew to $8,62,031.52. Now he used to buy a small quantity in a stock on pilot basis (for testing) and then if the stock moved in his favour he added more into it. He put a stop loss of 10% below the buying price of his stocks and followed the trailing stop loss thereafter. He bought Zenith Radio (5500 shares) Fairchild Camera (4500 shares) and Texas Instruments. In June 1959 he met with his three brokers who told him that his entire holding was $22,50,000 at that time. And that’s how he made his first 2 million.

I just hope that this story would inspire many struggling traders to follow a disciplined approach towards trading business.