Darvas Box Theory
A trading strategy developed in the 1950s by a dancer named Nicolas Darvas.
Darvas Box Theory is a trading strategy developed in the 1950s by a dancer named Nicolas Darvas. It is a theory based on the momentum of stocks. If a stock's price has risen in the past, it is bound to increase in the future and vice-versa.
Through the momentumof stocks, Darvas developed a method to find an entry and exit point from the market. Unfortunately, Darvas was not provided with modern advancements like the internet.
Everything took longer. Therefore, everything was more time-consuming than today. Darvas would gather information about every company either by traveling to different places and experiencing the world to gain knowledge or through newspapers.
It is unbelievablewas so accurate about the companies that he made 2 million dollars from the market with a starting capital of just $25,000 with little ups and downs in the road.
There have been controversies regarding how much he actually earns through this formula. However, even the least estimate of his earnings is $250,000. It means the worst-case scenario; he multiplied his wealth ten folds through the Darvas Box Theory, which is not at all bad.
Nicolas Darvas's journey to becoming an alleged millionaire through the stock markets was one of the most unusual ones. at the University of Budapest in 1951. Afterward, he trained as a ballroom dancer with his half-sister Julia.
Surprisingly, he was a natural at ballroom dancing and ultimately left the field of economics. As a dancer, he started going out on world tours and was introduced to the share market at a nightclub when he was paid in company shares rather than money.
He began investing as an amateur does. He followed the tips and bits of advice of other brokers. Unfortunately, with his orthodox approach to the market and lack of awareness about the behavior of the market, he ended up losing money rather than making huge profits.
To learn, he ended up reading almost 200 books about stock market trading. After being educated in this field, he realized he could not rely on the opinions and predictions of others to achieve success. Instead, he must create his method to gain prosperity through the stock market.
He started observing different trends and stopped letting anything or anyone influence his financial decisions. After years of research and practical experiences, he formulated Darvas Box Theory.
Basic Criteria for Darvas Box Theory
Darvas Box Theory was a trading tool developed by Nicolas Darvas. With the help of momentum theory and technical analysis, it helps determine when to enter the market to purchase a stock and when to get out of the market by selling it.
Nicolas Darvas was a master. Because of his profession, he used to travel the world while headlining dance tours. It enabled him to grasp various cultural changes that people were experiencing worldwide.
He used this ability to select and target industries with the optimum growth potential. He wanted to use his theory only on the stocks that showed an upward graph in the last 52 weeks. So, he only targeted companies from budding industries like the technology industry.
For selecting industries or companies, Nicolas used to perform fundamental analysis on various companies. For instance, he invested in Lorillard since cigarettes were a high-demand commodity back in 1950.
He mainly targeted companies based on two key indicators. First, an upward trend for a substantial amount of time, and second, the trade volume behind any stock. He did not choose cheap stocks, also known as penny stocks, due to them being highly volatile.
So, companies in the middle tier, with infinite growth potential, which were neither too cheap nor too expensive, were selected by Nicolas. These indicators were fundamental for the Darvas Box Theory to work.
How Does Box Theory Work?
Once Nicolas Darvas used to list the stocks he was interested in, he would observe them and their highs.
Since all the stocks had an upward trend, he noticed several highs in the 52 weeks. Through the Darvas Box Theory, Nicolas Darvas could determine the perfect time to enter and exit the market.
Boxes are formed throughout the financial year based on new highs that the stock experiences beginning with a 52-week high. Every time price goes higher than the high or top of the box, the trade gets triggered and is a sign to buy the stock.
Step 1 - Once a company is selected, the initial stage is to start forming the box, which begins with marking the new 52-week high. This also reflects the top of the box. When the price falls, the point from which it recovers becomes the bottom line of the box.
The box keeps getting elongated as the price fluctuation between the top and bottom of the box. The highs can be referred to as resistance and the bottom of the box can be referred to as support.
Step 2 - Once the price moves in an upward trend and breaks the box is when the trade is supposed to be triggered. The new high becomes the buy order. According to the risk percentage the investor is willing to take, a sell order is also determined.
Step 3 - If the price has touched the sell order, it is compulsory to sell the stock. According to Darvas, he never took major losses as he kept his ego aside and realized his mistake as soon as possible.
Assuming it continues moving upwards, then the trade stays in play until a new box starts getting formed. Once the price moves even above the second box, the trade ends with more capital gains.
A new sell order is also set for the new box, and if the price touches the sell order limit, according to Darvas, it is best if one moves away from the trade as soon as possible. It was his discipline that made his method successful.
Step 4 - The stock is observed even further to see if any box is getting formed. If the upward moving trend loses the pattern in a way that boxes cannot be formed, or if the stock starts moving downwards instead of fluctuating in a price range, the trade with that particular stock ends once and for all.
By adopting Darvas Box Theory, he managed to reduce his risk by many folds. He stayed adamant on the fact that he would never continue the trade if the price ever touched his sell order, which is a testimony of his control.
In theory, the strategy looks very easy and convenient, but the patience required first to select companies that match the criteria and then the control on his ego to move away from trade the moment he realizes his mistake about choosing a stock is immeasurable.
The research behind this theory to work was immense. Although he was a professional dancer, he spent eight hours understanding the market daily. His skill and understanding of the market earned him 2 million dollars.
How to mark a new 52-week high?
The first step of the Darvas Box theory is to mark a new 52-week high which eventually becomes the top of the box, also known as resistance. This is high that needs to be broken for a trade to initiate.
However, it is not as easy as it sounds. There are a few criteria that a high needs to have for being at the box's top.
To determine the top of the box, Darvas used a 4-day pattern. Every high needed to go through the test of time, particularly four days. Every high needed to be followed with prices lower than that for the next three days.
Any pattern and price would work in those three days till the time all those three prices were lower than the high mark on the first day. Once the 52-week high was determined, other steps to forming a box would follow.
Theory in practice
Darvas only got involved in growth industries like technology. However, he made an exception for Lorillard Tobacco Company. The company was selling Kent and Old Gold Cigarettes in huge numbers back in the day.
The Lorillard Tobacco Company was nowhere around the technology sector, but cigarettes back then were one of the industries that were booming and had tremendous growth potential. Therefore, an upward trend seemed possible.
He initiated his trade by buying 200 shares at 27.5 as the price reached above his newly marked 52-week high. He marked 26 as his. Unlucky for him, the prices fell right after a few days and reached 26. Therefore, he had to sell his shares and finish the trade.
The prices for Lorillard Tobacco Company stocks started rising again after a few days, which helped him get reassured about his judgment. So he entered the market once again by repurchasing 200 stocks at 28.75.
The price went up, another box formed, and the price crossed the second box, too, so Darvas ended up purchasing 400 stocks more at 35 and 36.5. He ended the trade when the stock price had finally touched 57. He ultimately made a profit of more than 60% within six months.
The volume of trade and market trends have only become easier to study because of technological advancements. Darvas's virtues and his disciplined approach to looking at the market and keeping negative feelings aside is something investors can learn from.
The theory worked very well for Nicolas Darvas. However, it cannot work for everyone in any situation. Moreover, it does have its limitations like:
1. It only works in bullish markets- Nicolas Darvas used to only invest in companies belonging to the growth industries. Americans were riding on the wave of technology, rockets, and missiles.
Therefore, he only invested in companies that were working towards bringing something new to these industries. His major income also came from companies producing commodities well-liked by the community.
He never invested in bear markets. Moreover, his theory works behind stocks having an upward trend. It is impossible to find companies with year-long upward trends in bearish markets.
2. Unpredictability- It is complicated to predict market trends. Although Darvas would exit the moment the stock prices would touch the sell order, it would still result in small losses occurring here and there.
It was his extensive research that enabled him to find companies that promised growth for the next 20 years in the 1950s. However, with the cut-throat competition, it has become even more challenging to find companies like that.
According to the line of the profession, he comes from, he amazed everyone back in the day. Nicolas Darvas found one of the optimal ways to determine the correct time to enter and exit the market by making clear markings for the buy and sell order.
However, the market has evolved a lot. People have started studying everything in depth, and with the, many things have become more convenient. The Research part has become less cumbersome because of the invention of the internet.
Moreover, every broker or investor nowadays uses a trailing stop-loss order, which has become one of the most fundamental bases for any technical strategy developed afterward. So, his technical skills may not be adopted by present investors.
The Bottom Line
In the 1950s, there was mass financial illiteracy, and, in those circumstances, a professional ballroom dancer educated himself and made 2 million dollars with the help of the stock market from a strategy developed by him. It is a monumental achievement even in today's day and age.
Nicolas Darvas, through his strategy, could determine when to enter and exit the market. However, the market has evolved, and people have gained more financial literacy. As a result, momentum theory and stop-loss orders have now become fundamentals of many technical strategies.
Furthermore, technology still comes under one of the budding industries. Still, the cut-throat competition and a completely different environment have made it difficult for investors to find companies with such upward graphs.
Several other strategies have now seen the light of the day that are more easily applicable to the present market scenario. Perhaps, the strategy is not as well suited as it used to be, or maybe it is simple and can be used to beat the market through proper money management.
However, Nicolas Darvas should still be appreciated for his patience and disciplined approach to the market. He could make so much money only because he did not let his ego become an obstacle to his decisions. He always stuck to his method and never doubted his research.
So, even if people do not want to adopt the technicalities of his strategy, they can still learn from his astute personality. His confidence in his methods was also unbelievable, and young investors can learn from Nicolas Darvas to trust their abilities.
Researched and Authored by Priyansh Singal | LinkedIn
Reviewed and edited by Tanay Gehi | LinkedIn
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