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Article by dailystock_admin    (04-25-09 07:06 AM)

How Nick Darvas Made 2 Million in the Market with the Box Theory

The Box theory of stock market trading was conceived of by Nicolas Darvas in 1958. An essential feature of the Box theory is that it indicates exactly when to enter or exit selected stocks based on certain characteristics or ‘personality’ of the stock, rather than by applying a general stop loss percentage as is normally done by many traders.

Nicolas Darvas, author of the Box Theory, led an interesting if chequered life as economist turned ballroom dancer turned successful stock investor! After gaining an education in economics at the University of Budapest, he fled the country in 1939 to escape the Nazi invasion using a forged visa, and reached Istanbul, Turkey. Circa 1953, he toured Europe and the U.S., teaming up with his half-sister Julia as a highly popular ballroom dancing pair. Alongside his dancing profession he developed a rare passion for the stock market, and undertook an in-depth study of the stock price mechanism. As he began to make investments on his own, he made an interesting observation. He had placed his funds on a couple of stocks that were at their 52-week high, and to his astonishment, the stocks continued to move even further upwards. Investing further, he had ended with a resounding win on these trades!

Darvas followed up on this uncanny behavior of the select stocks, and tried the same approach with other scrips he picked. He made $2,450,000 in 18 months, during the bull run of 1957-58.

What is most alluring about his trading system, is that he had consistent success with his strategy, which he was always fine-tuning to adjust to ever changing market conditions. He made huge profits when the market went up and his system was easily adaptable to a bearish market as well.

The Box Theory

Darvas observed that certain stocks that went up to new 52-week highs tended to rise even higher. He envisioned stock price ranges as a series of boxes. As long as the price was confined to a ‘box’ or price range, he waited. Just as the price rose out of the confines of the ‘box’ he would buy the stock and simultaneously set a stop-loss order under the box.

Darvas’ concept was based on the fact that each stock has its own characteristic traits which again depended on the type of traders trading in it. For instance, conservative traders generally invest in slower moving stocks, while the more risk-taking traders would go for faster moving stocks. If he set a stop loss at say 10 % on a particular stock, it may have worked to his advantage, but the same 10 % on the next stock stopped him out and then the stock moved up right after he got stopped out. Realizing thus that stock movements differ from scrip to scrip, Darvas devised a system of trading them differently.

Applying the Box Theory

Darvas created watch lists of several stocks that he selected from each industry. He focused on higher priced stocks which gave him an advantage in terms of trading commissions, given the commission rate structure prevailing at that time. He then awaited the signals for the stocks to begin to move, looking for heavy volumes of trade among his short list of scrips. At the first signs of unusual volumes, he began tracking daily prices. Choosing those stocks that were trading within a narrow price range, he defined certain limits. The upper limit was the highest price a stock reached in the current advance that had not been disrupted for at least three consecutive days. The lower limit was a new three-day low that held for at least three consecutive days. He would issue a buy order just above the top of the trading range and a stop-loss order just below the bottom of the price range. Once in a position, he trailed his stop based on the action in the stock. According to Darvas, the boxes often "piled up," as a result of which they formed new box patterns as a stock rose higher. Each time a new box formation was completed, Darvas raised his stop to a fraction below the new bottom of the new trading range.

Cons: The Box theory offers no indication of whether or not the market is on the ascendant or whether it portends a downtrend.

Pros: The Box theory works well in a bull market shows you all the proper entry points to get in on a stock as it breaks out of the box to the top side and moves forward to create the next box or consolidation area. It is more insightful than a rigid stop loss system, because it is based on the ‘personality’ of each stock.

It also requires you to put your stop loss at the bottom of a box but not until the new box is made. You then move your stop loss to the bottom of the box before the new box.

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