WHAT IS THE 'Darvas Box Theory'

Darvas box theory is a specific type of trading strategy that former ballroom dancer Nicolas Darvas developed in 1956. Darvas' trading technique involves buying into stocks that are trading at new highs. A stock creates a Darvas box when the price of a stock rises above the previous high but falls back to a price not far from that high.

BREAKING DOWN 'Darvas Box Theory'

The Darvas box theory is type of momentum strategy. The Darvas box theory uses market momentum theory along with technical analysis to determine when to enter and exit the market. It also uses fundamental analysis to determine what to buy or sell. If the price breaks out of the Darvas box, the investor takes this as a sign of a breakout. This is how the Darvas box helps traders determine at what price to enter and exit the market.

The strategy traces its origins to 1956, when Nicolas Darvas turned a $10,000 investment into $2 million over an 18-month period using this theory. While traveling as a dancer, Darvas obtained copies of The Wall Street Journal and Barron's, but only used the listed stock prices to determine his investments. Critics of the Darvas box theory technique attribute Darvas’ initial success to the fact that he traded in a very bullish market, and assert that his results cannot be attained if using this technique in a bear market.

The Philosophy Behind the Darvas Box Theory

The Darvas Box theory depends on the central idea that in order to deploy the strategy the investor must focus on growth industries, meaning industries that investors expect to outperform the overall market. When developing the system, Darvas selected a few stocks from these industries and monitored their prices every day. While monitoring these stocks, Darvas used volume as the main indication as to whether a stock was ready to make a strong move, such that a significant increase in volume increased the likelihood of a big move.

Once Darvas noticed an unusual volume, he created a Darvas box with a narrow price range. In the box the stock’s low for the given time period represents the floor. He then used the stock's high for the time period as the ceiling of the box. When the stock breaks through the ceiling of the box, the Darvas box theory dictates that the trader should buy the stock. The alternative is also true: when the stock goes below the floor of the Darvas box, the trader should sell.

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