Last Updated on 11 September, 2023 by Samuelsson
There are many trading methods invented by unique individuals with deep insight into the market, and the Darvas box is one of them. The Darvas box was very profitable that the man who created it used it to turn a few thousand dollars to 2 million dollars. You may be wondering what the Darvas box is.
The Darvas box is a techno-fundamental trading technique that involves buying exciting stocks that are making new highs. The trading approach combines fundamental factors with momentum principles to identify the stocks to buy and when to buy them. It involves drawing a box around the recent highs and lows to establish the potential entry point and stop-loss levels.
This topic will be discussed under the following subheadings:
- What is the Darvas box?
- Principles of the Darvas box
- How to plot the Darvas box
- How to trade using the Darvas box principle
- Limitations of the Darvas box concept
- Practical tips the Darvas box concept
What is the Darvas box?
The Darvas box concept is a technical trading strategy used to trade high-momentum stocks. It is a trend-following system, so it helps you to get into an already-established trend, rather than predict a new trend. This trading strategy uses the combination of technical analysis and market momentum theory to indicate the appropriate time to enter or exit the market.
It involves buying into stocks that are trading at new highs. To know when to buy, the trader draws a box around the recent highs and lows to establish an entry point and the potential stop-loss level. With this technique, a stock is considered to be in a Darvas box when the price action rises above the previous high but falls back to a price not far from that high. The entry signal is a breakout above the upper border of the box.
Many trading platforms now have the Darvas box as a trading indicator that investors can apply to their charts to identify tradable price consolidations around the most recent highs. The indicator can show them when to enter or exit the market. It works when highs and lows in the market are updated over time, a line is drawn along highs and lows to make the Darvas box.
According to the strategy, a trader should consider trading only in rising boxes and monitor the trend or movement below the box as a signal for when to exit the market or update a stop-loss order. With the strategy, the trader only enters stocks that were in confirmed uptrends break out of consolidation patterns to make new highs. For example, if the box is between $35 and $40, then the trader buys when the price closes above $40 and sells when it falls below $35.
The origin of Darvas box strategy
The strategy was named after Nicolas Darvas, who created and traded it in the 1950s and explained the concept in his 1960 book, “How I Made $2,000,000 in the Stock Market.”
Darvas’ story was quite dramatic: he fled his native Hungary ahead of the Nazis in the 1930s and eventually reunited with his sister. Following the end of World War II, they formed a dancing group in Europe, and by the late 1950s, they were the highest-paid dance team in show business. Nicolas Darvas was in the middle of a world tour, dancing before sold-out crowds when he began trading and created his Darvas box strategy.
Darvas would obtain copies of The Wall Street Journal and Barron’s to research the stocks to buy. He focused mostly on the listed stock prices. By drawing boxes and following strict trading rules, Darvas was able to turn a $10,000 investment into $2 million over an 18-month period. This outstanding success led him to write the book, “How I Made $2,000,000 in the Stock Market”, popularizing his Darvas box theory.
While many still use the original Darvas box strategy, there are variations to the strategy that focus on different time periods to establish the boxes or simply integrate other technical tools that follow similar principles such as support and resistance bands. Note that the original Darvas strategy was created at a time when information flow was much slower, without anything as real-time charting. The availability of computer trading and real-time price charts now makes it easier to identify trades and set entry and exit points by applying the boxes to the chart.
Principles of the Darvas box
As we stated earlier, the Darvas Box concept is based on the principle of price momentum in stocks. The momentum theory simply implies that stocks that are rising are more likely to keep rising in the future while stock prices that were falling previously are more likely to keep falling in the future.
By drawing boxes around the recent highs and lows and aiming to trade the breakouts, the strategy aims to trade only stocks with the best momentum. It tells traders to buy only when the stock breaks above the upper border of the box, which lies at the most recent high, and exit if the price falls below the lower border of the box.
It is important to buy the right stock. Darvas prefers stocks with enough liquidity as evidenced by huge trading volume. Also, the stock must be enticing to the public, with new products and services that the public low.
If all these are present, the trader should wait for the stock to rise above its 52-week high. The stock’s 52-week high represents the floor of the box, and when the stock price reaches a new 52-week high and then falls from that high or at least doesn’t penetrate that high for three days, that new 52-week high becomes the top of the box.
The trading rule is simple: buy the stock when it goes above the upper border of the box; sell the stock when the stock goes below the lower border of the box. When the stock hits a third 52-week high, a new box forms, with the second 52-week high becoming the floor and the newly formed third 52-week high becoming the top of the box. This way, boxes can pile up as the stock progresses, and you can use the floor of each new box to track your trailing stop.
The Darvas trading rules can be summarized as follows:
- Identify a stock with huge volume and enticing products
- The stock is making a new 52-week high
- After the high is set, there are three consecutive days that do not exceed the high
- The new high becomes the top of the box and the breakout point leading to the new high becomes the low of the box
- Buy the break of the box once it exceeds the high by a few points
- Sell the low of the box if it is breached
- You can add to your position as it moves into each new box or simply trail your profit using the floor of the next box as a guide
While this may sound like a lot, it’s pretty straightforward. The seven steps show you how to find the stock to buy and also provide you with the entry and exit criteria.
How to plot the Darvas box
Many trading platforms have a built-in Darvas box indicator that automatically plots the box on the price chart once the indicator is loaded on the chart. However, if you want to manually plot the Darvas box by yourself, here are the steps to follow:
- Establish a trend: There has to be a trend for the Darvas box method to work. The market has to be in an uptrend (you look for buying opportunities) or a downtrend (in this case, short-selling opportunities).
- Find a new high: Find the most recent 52-week or 252-trading-day high. You may also use a different timeline.
- Establish the top of the box: The top is generated by a four-day pattern: the first day is the high found in the first step; this is followed by three days of lower highs. These price actions can be of any value as long as they are all lower than the first high. Once this pattern is found, the high becomes the top of your Darvas box.
- Identify the floor of the box: After establishing the top of the box, the next thing is to identify the bottom of the box. Starting from the low of the first bar, you find a pattern of three consecutive higher lows. Once you have established the pattern, the lowest low since the first high becomes the bottom of the box.
- Extend the upper and lower borders: The end of the box is extended until it’s breached. A breach can be a close or just the shadow piercing through the boundary. A price close is mostly preferred by experienced traders, as it shows sustained price movement in that direction.
Take a look at the chart below:
From the chart above, you can see that the new highest high is found (green arrow). This gives us both the start date and the top value of the box. Notice that the next 3 days after that new high, made lower lows (blue arrow) than the first high. So, that high becomes the top of our box.
Notice that starting from the lowest low of the first bar (blue arrow), the next 3 consecutive days (black arrow) did not make a new lowest low. So, at this point, the lowest low becomes the floor of our box.
There are other variations of the Darvas box. So, another way to plot the Darvas box is to wait for the stock to rise above its previous 52-week high so that this previous 52-week high becomes the floor of the box, while the next 52-week high becomes the top of the box if the price does not penetrate that previous high after falling for three trading days. In this case, the concept of support and resistance is merged with the Darvas box concept.
When the stock hits a third 52-week high, a new box forms, with the second 52-week high becoming the floor and the newly formed third 52-week high becoming the top of the box. This way, boxes keep piling up as the stock progresses, and you can use the floor of each new box to track your trailing stop. See the chart below:
How to trade using the Darvas box concept
Although the Darvas box strategy is largely based on technical analysis methods, Darvas combined it with some fundamental analysis to determine what stocks to trade. He believed his method worked best when applied to companies with the greatest potential to excite investors and consumers with revolutionary products, as well as companies that had shown strong earnings over time, particularly if the market overall was choppy.
Since Darvas applied a distinctive fundamental filter when looking for stocks to trade, it makes sense to use some fundamental factors too. Focus on stocks with innovative products and high earnings growth. You may also check their management and other fundamental analysis essentials.
Coming to the technical aspect of the Darvas method, make sure that the stock you trade have high liquidity. The average daily trading volume should be more than 2 million shares. If these check out fine, you go ahead to apply the Darvas box indicator on the chart or manually draw it following the steps we discussed in the previous section.
After the box has been plotted on the chart, you simply wait for a signal. The trading rule goes like this: buy the stock when it goes above the upper border of the box; sell the stock when the stock goes below the lower border of the box. However, there are a few things to keep in mind: Look for only buying opportunities in an uptrend and only selling opportunities in a downtrend.
So, this is what you do:
- The price is in an uptrend: If the price closes above the top of the box, it is a signal to buy. If it closes below the bottom of the box, you should ignore the signal.
- The price is in a downtrend: If the price closes below the bottom of the box, it is a signal to sell short. If it closes above the top of the box, you should ignore the signal.
Limitations of the Darvas box concept
The Darvas box strategy works on the basis of price momentum, so there must be a strong trend for it to have a chance of being profitable. This is why many critics of the technique attribute Darvas’ initial success to the fact that he traded in a very bullish market; they assert that his results cannot be attained if using this technique in a bear market. While this may be true, the strategy produces small losses overall when the trend doesn’t develop as planned.
Moreover, the key is to make the right trade in the right market condition. In a bull market, it is best to look for buying opportunities. Likewise, in a bear market, it is best to look for short-selling opportunities. This way, the trader is always trading in the direction of the price momentum.
Also, using a trailing stop-loss order to track and lock in profits as the trend develops helps to improve profitability. Just like many other technical trading strategies, the true value in the Darvas box strategy may actually be the discipline it develops in traders when it comes to controlling risk and following a plan. Even Darvas emphasized the need to keep a trading journal; he would record his trades in his book and later analyze them to know what went right and wrong.
Practical tips for using the Darvas box concept
The Darvas box technique might be more than 7 decades old, but it still works when applied in the right way in the right market condition. To get the best out of the strategy, apply the following tips:
Look for stocks in the early stages of a high-momentum trend: The Darvas box strategy works based on price momentum — the idea that a stock that is rising would continue to rise. It’s best to use it in stocks that are showing high momentum.
Go for stocks with high average daily trading volume: The higher the liquidity, the better. Trading only liquid stocks reduces the effects of undue volatility. You can easily buy and sell the stock at any time.
Make sure you place a stop loss order: It is important you place a stop loss order each time you place a trade so as to void huge losses. Interestingly, the Darvas box strategy shows a clear stop loss level — below the bottom of the box for a buy order and above the top of the box for a sell order.
Use a trailing stop to lock in profits: A trailing stop can help you lock in profit as the trend progresses. You may use an automated trailing stop or manually move your stop loss order to a little below the floor of the next box (in the case of a long position).
Be mindful of your position size: Always trade with what you can afford to lose. The rule is to commit only 1-3% of your trading capital in a trade. However, you can scale in as the market progresses in your favor and form new boxes.
Another great article about Nicholas Darvas: Nicolas Darvas – How I made $2,000,000 In The Stock Market | (Review And Summary)