Darvas Box Theory

A trading strategy used to target stocks with pricing and volume as indicators

What is the Darvas Box Theory?

The Darvas Box Theory was a trading strategy that was invented by self-taught investor Nicolas Darvas, who used to target stocks with pricing and volume as indicators. It makes the Darvas Box Theory similar to technical analysis, which is a trading discipline that is applied by security traders who observe patterns within historical trading data and attempt to analyze securities with the underlying trading data.

 

Darvas Box Theory

 

The Darvas Box trading strategy involves buying stocks that are trading at new highs of prices and drawing a box around the prices’ recent highs and lows to establish an entry point and an exit point for a stop-loss order.

Stocks are considered to be trading within a Darvas Box when the price rises above the previous high but subsequently retracts to a price that is relatively close to the high.

 

Understanding the Darvas Box Theory

 

Origin

Nicolas Darvas was traveling the world as a ballroom dancer in the 1950s when he obtained subscriptions to The Wall Street Journal and Barron’s and only used the listed stock prices to determine what stocks he would invest in.

Darvas would draw boxes and follow trading rules to turn a $10,000 initial investment into $2,000,000. His success led to a book that he wrote called How I Made $2,000,000 in the Stock Market and made the Darvas Box Theory very popular.

The Darvas Box Theory is applied today through technical analysis. Technical analysis utilizes boxes or other technical tools that follow underlying principles, such as support, resistance bands, and momentum. Darvas applied his strategy when the flow of information was much slower, and technical charting was impossible. The same principles Darvas used could be applied with technical charting.

 

How It Works

The Darvas Box Theory is a trading strategy that follows the momentum of stocks. The momentum theory simply states that stock prices that increased previously are more likely to increase in the future. Conversely, stock prices that were decreasing previously are more likely to decrease in the future.

The theory gave insight on when to enter and exit certain positions by drawing boxes around the highs and lows over time. It instructs practitioners to only take long positions in rising boxes and use the highs of those boxes to set exit points. So that if a stock price fell below that exit point, the stock should be sold.

 

Darvas Box Theory - Example
Source

 

The Darvas Box Theory appears to be a purely technical trading strategy – which is a strategy that only uses pricing and volume information to inform investment decisions. Darvas did use fundamental analysis as well to determine which stocks to target.

Fundamental analysis includes observing qualitative and quantitative factors of individual investments to inform investment decisions. Darvas would target sectors or industries that offered high excitement potential for investors and consumers and were creating revolutionary products. Darvas would also screen for companies that maintained healthy earnings growth over time as well.

 

Insights from the Darvas Box Theory

Although the Darvas Box Theory at its time was very successful, it likely would not be as effective in the modern investing world. The information efficiency today is far greater than when Darvas experienced his success. Despite the fact, some key insights can be derived from the theory, namely:

  • Focusing on growth industries
  • Investing in high-volume securities
  • Use of stop-loss orders

 

Darvas encouraged investors to focus on stocks with high volume since it was an indicator that a stock was making strong moves. Such a practice may be limited today since a lot of trading volume is created by algorithmic, non-human traders.

He used stop-loss orders to minimize losses and take gains off the table from positions. A stop-loss order is a free order instruction that instructs a broker to sell a position after it falls below a certain point. It can help to limit losses in positions and set a free insurance policy.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Algorithm Trading
  • Defensive Stock
  • Momentum Indicators
  • Trade Order

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