Successful Darvas trading comes down to one essential principle: cut your losses short and let your profits run. Sounds simple enough, but it’s easier said than done.
In order to cut your losses and protect the money you already have, you need to ALWAYS have an initial stop-loss in mind before entering any new trade. This initial stop is the point that you will sell your stock if the trade goes against you.
This initial stop needs to be close enough to your buy point to keep your losses small, but far enough away from your buy point to avoid getting stopped out on a “normal” pullback.
Where should your initial stop go in order to avoid a worst-case drop?
Should it be 5%-8% below the buy point, as traders like William O’Neil recommend?
Should it be 10% below the buy point as traders like Nicolas Darvas himself and Gerald Loeb recommended?
What about the Darvas Box midpoint, as I have recommended to beginning traders in the past?
Some traders have suggested selling if the stock falls just $1 below the price you paid for it; would that be the ideal place for an initial stop?
Actually, ALL of these options are good. You can do well with each of them.
But what’s the very best – the most efficient and effective – method for setting an initial stop?
I have found that the best place to set your initial stop should be at the intraday low of the breakout session. The overwhelming majority of successful breakouts will not violate this intraday low.
For example, when WYNN recently broke out of its Darvas Box (assuming you had made your initial purchase on the day of this breakout), you would have wanted to set your stop at the intraday low WYNN established on that breakout day.
See the chart below:
There are times when some discretion should be used (such as when this stop is within a few percentage points of another key support level), but as a general rule, you should always set your initial stop this way.
When you have your initial stop established, you can then adjust your position size to ensure that you are never risking more than 2% (at the most) of your portfolio on the trade.
The drawback to setting an initial stop this way is that it can sometimes be too tight. There are times when a stock breaks out, violates this initial stop-loss, and then turns around and surges higher, on its way to a nice long trend.
When this happens, you would want to buy the stock right back when it hits new highs on strong volume. This can be frustrating and it can be hard to turn around and buy a stock that you just sold, but trading isn’t always easy.
The good news, however, is that the large majority of successful breakouts will not violate this initial stop. Most stocks that violate this stop end up failing.
Remember: your number one objective as a trader is to not lose money. Some losses are unavoidable, but they need to be kept as small as possible. Once you have mastered this first objective of trading, you’ll be able to enjoy the benefits of your second objective: to make large profits.
But, you’ll never achieve your second objective if you violate this first objective and fail to protect the money you already have.