Darvas Box Theory Explained
The Darvas Box Theory is a unique approach to trading the markets. It is one of the most widely used trading strategy in the stock markets today and includes both day traders as well as swing traders.
Table Of Contents:
- Darvas Box Theory Explained
- Who is Nicolas Darvas?
- What is the Darvas Box theory?
- Darvas Box theory rules
- Constructing the Darvas box
- Fundamentals of choosing stocks for Darvax box theory
- Risk management in Darvas box
- Does the Darvas box work in the forex markets?
- The Darvas box theory – Conclusion
The name, Darvas box comes from the fact that it was developed by a trader and an investor, Nicolas Darvas. You might be wondering why people use the Darvas box. Well, this comes due to the fact that Nicholas Darvas managed to turn a fortune, trading with his self designed method of analyzing the markets.
Nicholas Darvas shot to fame after he wrote his book, “How I made $2,000,000 in the stock market.” In the book, Darvas outlined how he was able to make so much money by using his trading method of using boxes.
From here, this style of trading became to be known as the Darvas Box method.
The Darvas Box method of trading is a combination of both technical analysis and fundamental analysis. In his journey to making his two million, Darvas carefully combined the two main fields of study when it comes to the financial markets.
Darvas primarily focused on using volume along with price to assess the security and to make potentially profitable trades. To put it in simple terms, Darvas uses the 52-week high and low on volumes, rather than price.
If you switch on CNBC or Bloomberg, you will find people talking about stocks making 52-week highs or lows. But Darvas focused instead on volume, reaching a 52-week high or a low. This makes the method of trading with Darvas boxes very unique.
The Darvas Box Theory applied to Starbucks stock chart (SBUX)
As you can imagine, Darvas focused on volume in an effort to gauge the momentum of the stock price. This was one of the reasons why he was able to make money so quickly. Many investors often end up holding stocks that give meagre returns but take a lot of time. With Darvas, it was the opposite. His method focused on stocks with momentum which tend to give higher returns in a short span of time.
But there are risks of course with this style of trading. Momentum stocks can give you profits very quickly, but they can also erase your gains just as quickly too. But Darvas was able to manage his risk by using technical analysis.
You can see the strong connection between fundamental analysis and technical analysis and how when you use these two fields of study, you can build a robust trading strategy.
Who is Nicolas Darvas?
The story of Nicolas Darvas is one of inspiration and a success story for many reasons. What makes Nicolas Darvas and his trading strategy so widely accepted is the fact that just about anyone can relate to him.
In his book, Darvas reveals how he had no prior knowledge about the markets. His credibility was built after he was interviewed by the Time magazine where he said that the money he made in the stock markets came despite his lack of knowledge about the markets or insider information. In fact, Darvas did not have any connections to Wall Street.
This is what makes Darvas’ story to stand out. Nicolas also manages his own website, www.darvas.com where he outlines in detail about his work and also gives a glimpse into his background.
According to sources directly from his website, Darvas was a professional dancer. He states that he travelled around the world with his half-sister and they founded their dance company in the 1950’s. During the time, Darvas’ obsession with the markets started to grow. He was amused and fascinated how markets worked and the internal dynamics of what moved the prices.
As a result, Darvas started to teach himself how to trade. He began by reading a number of books over a period of time. Following this, he gained quite some knowledge and also started to develop some trading ideas. Darvas initially started by investing in a few stocks whose prices had increased.
Overtime, he continued to work on his trading strategy until he mastered the art of using boxes. At the time, he called it The Box system, which we all know today as Darvas boxes.
One of the things that stands out from Darvas’ success was that he was able to turn a massive profit at a time when electronic trading was still nascent. Back in his days, Darvas did not have access to automated charting tools or advanced techniques that we have grown used to in this day and age.
Darvas began his venture into the markets by investing $3,000 in stocks. Within 18-months, Darvas managed to turn this into a profit of $2,450,000.00. In today’s time this amounts just a bit under three million in profit.
But of course, many talk only about the profits Darvas made. In fact at one point in his trading journey, Darvas lost a $100,000 in a matter of a month. He was obviously devasted by this huge loss. Darvas took a short break to recoup from his losses and came back to the markets better prepared.
Over the course of his journey, Darvas constantly perfected his box theory.
It is no wonder then that traders flock to the Darvas box theory trading method in hopes that they too can make a profit. So, let’s take a look at the Darvas box theory.
What is the Darvas Box theory?
The Darvas Box theory is basically a trend following system. But unlike most other trend following strategies, the Darvas Box theory does not predict or anticipate a market move. On the contrary, it only reacts to the market trends.
There is a significant difference between these two approaches. When you use a trading system that is anticipating a market move, chances are that you might be wrong or right. But you cannot be right all the time. As you know, the markets are irrational. Therefore, there are times when you right on the money, but there are times when the markets prove you wrong.
Using a reactive method of trading means that you as a trader, react to the price action. You basically allow price to do whatever it wants and then based on what price does, you trade accordingly.
The way the Darvas Box theory works is to begin with looking at stocks that have a huge trading volume. Darvas then analyzed these stocks and then bought the stocks when they rose to a 52-week high.
The box which Darvas drew was a box. The top end of the box was the ceiling, representing the 52-week high. When prices failed to break the 52-week high after three trading sessions, that became the top of the box.
When price retreated from the 52-week high, the resulting lows became the floor of the box. Thus, the Darvas box is drawn. Following this (meaning that after the Darvas box is plotted), Nicolas Darvas bought when price retraced back to the 52-week high and then broke above it.
Alternately, he would short when the stock fell from the lower end of the box, as it indicates that price failed to break the 52-week high and instead fell through the floor. Stocks, when reaching 52-week highs often come backed by heavy volume and momentum. Thus, Darvas was able to exploit the momentum to his advantage and managed to turn his $3000 into millions.
Darvas Box theory rules
The rules of trading with the Darvas box theory is very simple, as outlined below.
- Look for stocks or securities that are making a new 52-week high
- Then filter these stocks or securities which have retreated from the 52-week high for three consecutive days
- The new 52-week high is the top of the box. The breakout prior to reaching the 52-week high is the low
- After the low is formed, price should not break that low for at least three days
- Buy the breakout of the box, i.e: stock breaks its recently formed 52-week high
- Sell if the breakout is at the bottom of the box
The Darvas box basically acts as your trading plan and you buy or sell automatically. To do this, Darvas recommends using automatic limit orders. For example, you would place a buy limit order a few points above the breakout of the box. It is also recommended to set a sell order to limit your losses if it fell below a certain threshold in the box.
Thus, when you set the automatic buy and sell orders, you are already defining your risk. For the target levels, Darvas box takes an open ended position. Meaning that when there is a breakout from the Darvas box, you simply continue to analyze the stock (the price and volume).
This would result in you plotting another Darvas box (on top of the previous one) and continue to analyze the position and set the automatic stops and limit orders. This way, you are able to build up your positions while riding the momentum.
Below is an example of another stock chart that uses the Darvas box. The below example of Darvas box is based on the rules that a stock much hit a 52-week high and then retrace for at least three trades. We also consider the volume factor as well.
Darvas Box theory with trading rules
You will notice how the Darvas box does not anticipate the price change but lets you to only react to the price change. When the momentum is strong, the markets will allow you to profit from them as you continue to draw the Darvas boxes.
When the momentum weakens, you can expect price to reverse and thus you would be stopped out, but with a profit in your hand.
Based on the filters that you use to scan the stocks that qualify for the Darvas box theory, you can manage multiple trades at a time. However, do not get too engrossed into creating new positions.
One of the major factors that determines the profitability of the Darvas trading method is to continue building up on the momentum from the stock that you are already trading. This allows you the chance to better manage your risk while making profits on the stock’s momentum.
Constructing the Darvas box
The first step in construction the Darvas box is by scanning the markets for stocks that have made a 52-week high. You can use various stock scanning tools such as Finviz for example to find such stocks.
You should also pay attention to the volume of the stocks as well. Below is an example of the stock screener based on the Darvas rules of high volume and stocks at 52-week highs.
Darvas Box Theory Stock Scanner
Based on the above scanner, we can see that there are about nine stocks that qualify for constructing the Darvas box. The above scanner takes into account stocks that hit a 52-week high and retreated 3%, the minimum level to quality for a Darvas box.
You can use your own charting platform to see how these stocks have performed after hitting the 52-week high. Below is an example of Cisco Systems (CSCO), where price hit a 52-week high and has retreated for 2 days so far, at the time of writing.
Example of Cisco Systems (CSCO) using Darvas box theory of 52-week highs
The above example is only to show as an illustration on how you should be combining the fundamental and the technical concepts that are used in the Darvas box. In a way, the Darvas box shows the trend and also the momentum.
As discussed early on in this article, the Darvas method of trading is a mix of trend following that is reactive to the price rather than predicting price action. But at the same time, there is a balance as being too reactive to price will mean that you will miss a major part of the momentum led breakout.
Fundamentals of choosing stocks for Darvax box theory
In his experience, Darvas also fine tuned the stocks that he would trade. In fact, Darvas follows the principle of buy dear, sell dearer.
Thus, as a filter, Darvas only choose stocks with a minimum price of $30 or more. One of things mentioned is that Darvas did not pick cheap stocks or those that were very volatile. One way to interpret this is by setting a limit on the stocks’ market capitalization.
In this aspect, traders should choose stocks that are large cap at the very least and those that are priced between $50 - $30. Back in the mid-1950’s, Darvas had a preference for tech stocks.
Technology stocks are known to be led by momentum and makes for great picks as they can give you big returns. Thus, you could use the same approach and pick similar technology stocks, but of course those that are not highly priced.
Risk management in Darvas box
Risk management in the Darvas box theory is not widely talked about. However, Darvas himself mentions that risk management is an important aspect. He stresses on using the break-even level when trading with Darvas box.
Firstly, to calculate the breakeven level you should account for the transaction costs and other brokerage fees that are often ignored. It is recommended that you use a minimum breakeven level before taking away the risk from the trade.
There is also a strong emphasis on the fact that a successful trade is a mix of good risk management and money management skills. Darvas reiterates many times that traders should do their homework at regular intervals.
This includes researching into the fundamentals of the stock before entering the trade and also to research the stocks after the trade has moved into profit. There is also quite a bit of importance given to pyramiding your trades. This means, plotting multiple Darvas boxes as the stock continues its trend.
You keep adding to your positions while trailing your stops. Of course, Darvas recommends that you should carefully analyze the stock every time you are adding to the position, when the stock allows for it.
You can see that there is quite a bit of work involved. Many traders these days believe that they can simply buy the breakout of the Darvas box and expect to get rich. But this is not always the case.
Does the Darvas box work in the forex markets?
There are customized Darvas indicators designed for the forex markets. You will find many Darvas box indicators for the MT4 platform. But there is a fundamental flaw in applying this strategy.
If you observe carefully, Darvas built his trading system to work with the stock markets. A great deal of emphasis was put on the fundamentals of the stocks such as volume and the 52-week highs.
While 52-week highs are something that can be seen even in the currency markets, then comes the question of volume. Forex markets are traded over the counter. Therefore, there is no accurate way to see the actual volume. The volume that you see on a standard MT4 trading platform is nothing but the volume from within the broker’s liquidity pool.
There is no telling how much the real volume is in the forex markets. Thus, the lack of this fundamental parameter instantly dismisses the pros of using the Darvas box.
On the other hand, momentum is a common feature when it comes to the forex markets. But again, the lack of volume makes forex a poor choice of markets to implement the Darvas box theory.
Given the fact that traders are always fascinated by a trading system that has proven to make someone rich, there is no dearth in how far the Darvas trading system has been modified, to the point that the trading rules are greatly different from the original Darvas box trading theory.
The Darvas box theory – Conclusion
In conclusion, the Darvas box theory is something of a fascination with traders. This is largely due to the fact that Nicolas Darvas was able to make a huge fortune in the markets in a short span of time.
Many traders tend to focus on this fact alone but miss the homework and the research that is often unnoticed. As mentioned, at one point Darvas lost close to a $100,000. This goes to show that the trading system is not the Holy Grail but rather a system that requires a lot of self discipline and practice and fine tuning.
Having said the above, the Darvas box theory is a complete trading system that is built for the stock markets primarily. These days the Darvas box theory has been put to use in other markets as well.
Remember that volume is one of the most important aspects in using the Darvas box theory. Therefore, it is best to apply this to the stock markets, rather than forex where volumes are questionable and the futures markets which behave very differently compared to stocks.
There is also a lot of emphasis on risk management and being disciplined when it comes to trading with the Darvas box. This is something that many other trading systems miss. For the most part, when you come across a trading system, you will find that focus is given only to the trade entry and exit but not much thought is given to the principles of risk and money management.
In this context, the Darvas box gives you a full insight into the fundamental analysis, the technical analysis, the risk and money management aspects as well.
After Darvas designed his box trading system, there hasn’t been anyone else who managed to make such a fortune as Darvas did. This could partly be due to the fact that quite often traders tend to drop things that they find to be irrelevant or simply ignore the basic rules that are outlined.
Various chart examples show that the Darvas box theory does indeed work. But in order for the box theory to work for you, you need to put in a lot of effort into researching the stock and also to be patient when it comes to trading and managing risk.