The Darvas Box Theory is a trading strategy that identifies stocks trading at new highs on correspondingly high volumes. Developed by Nicolas Darvas, the theory is rooted in technical analysis and aims to help investors capture significant price movements.
History and Background
Nicolas Darvas, a successful dancer and self-taught investor, developed this theory in the 1950s. He outlined his strategy in the book “How I Made $2,000,000 in the Stock Market” published in 1960, which provided insights into his method.
Fundamental Principles of Darvas Box Theory
- Identification of Boxes: Stocks are analyzed to form ‘boxes,’ where the top is defined by recent high prices and the bottom by recent low prices. Movement outside this box signals potential buying or selling opportunities.
- Volume Confirmation: Darvas emphasized the importance of high trading volume to validate price movements.
- Stop-Loss Mechanism: Use of stop-loss orders to minimize potential losses if the stock price moves unfavorably.
How to Construct a Darvas Box
Step-by-Step Guide
- Identify a Stock Reaching a New High: Track stocks making new highs and monitor for increased trading volume.
- Draw Initial Box Boundaries: Establish the top and bottom of the box based on recent price highs and lows.
- Monitor Price Movement: Watch for the stock to trade consistently within the box and look for a breakout.
- Execute Trades: Buy the stock if it breaks above the top of the box with significant volume. Use the bottom of the box as a stop-loss point.
Examples
Consider a stock that recently reached a high of $100 with a corresponding low of $95 over a period. This range forms the initial Darvas box.
- If the stock moves above $100 and volumes are high, it suggests a potential uptrend.
- Place a buy order at $102 and a stop-loss order at $95.
Applicability of Darvas Box Theory
Pros
- Clear Entry and Exit Points: Provides a systematic approach to trading.
- Volume as a Key Indicator: Incorporates volume to verify trends, reducing false signals.
Cons
- Requires Active Monitoring: Frequent tracking of stock prices and volumes.
- Risk of False Breakouts: Potential for false breakouts which may lead to losses.
Related Terms
- Technical Analysis: The study of past market data, especially prices and volume, to forecast future price movements.
- Breakout: A stock price moving outside a defined resistance or support level with increased volume.
- Stop-Loss Order: An order placed to sell a stock once it reaches a certain price to limit losses.
FAQs
What is the primary goal of the Darvas Box Theory?
The primary goal is to identify and profit from stocks with the potential for significant upward price movements confirmed by high trading volumes.
How does volume affect the validity of a Darvas Box?
Volume expansion during a price breakout from the box is a key indicator, reinforcing the likelihood of a sustained trend.
Can the Darvas Box Theory be automated?
Yes, automated trading systems can implement the Darvas Box Theory by programming the rules for box formation and breakout detection.
References
- Darvas, N. (1960). How I Made $2,000,000 in the Stock Market.
- Murphy, J.J. (1999). Technical Analysis of the Financial Markets.
Summary
The Darvas Box Theory, introduced by Nicolas Darvas, provides a structured trading strategy focused on stocks reaching new highs with increased volumes. Through its clear methodology involving box formation and volume analysis, it offers traders a systematic approach to identifying profitable trading opportunities while managing risks through stop-loss orders.
