Darvas Box Theory Explained
What follows is an explanation of the Darvas box method according to my interpretation of his seminal book. I stress that this is only my interpretation. Care to discuss yours? Write me.
A quick poke around the web with your favorite search engine will show many websites on the topic of Darvas box theory (or some other variant, such as Darvas box method, Darvas boxes, etc.). Some are quite vague, others try to sell you things. You will find no testimonials on this site. I'm not trying to sell you anything (although if you make some money and want to donate some to your favorite charity, I'm sure they won't mind). On this website, on this page in particular, I aim to demystify the Darvas box theory system of trading stocks, a system which I think excels as a bullish breakout system.
For starters, Darvas notes in the appendix of his book (on page 194 of my copy) that the following information about a stock are necessary concomitants to the success of his system:
- An all-time high
- High and low for the past two or three years
- Weekly price range and volume for at least the last four to six months
Darvas starts to explain his box theory system on page 51, and continues until page 56. So you see, this entire system is described in only six pages, most of which were example boxes! Amazing, no?
The Basic Box Theory
The Darvas box theory is a momentum strategy for use with a short-term trading style. When I saw short-term, I don't mean day trade, although I suppose that is possible as well. I mean short-term in the sense that one tends to hold the stock for less than a year. However, the exit points are not very well defined by Darvas. His only remark is that he sells when the stock penetrates the box to the downside. Seems clear enough, I guess.
At its core, the Darvas box theory system is ludicrously simple: All one needs to do is read and understand the price action of a stock! Watch for the price of a stock to form a 'box', with a lower bound and an upper bound. When, like a set of pyramids, the boxes pile one on top of another, the opportunity to buy occurs when the stock penetrates the uppermost part of the topmost box.
According to Darvas, the stock could bounce around inside the box as long as it liked; he would not buy it unless it penetrated the uppermost box. In fact, he stated that he would be concerned if the stock did not bounce around. Darvas graphically shows this idea on page 189 of his book. However, Darvas himself claimed never to have charted a single stock. He called himself a mental chartist.
A Darvas box is basically an area of consolidation. For whatever reason, the market has decided the stock should neither advance nor decline appreciably, but rather idle sideways. When I chart, I prefer to use bars rather than lines, for the simple reason that the line chart is not precise enough. In his telegrams, Darvas requested high, low, and close for his stocks, so at a minimum that is what we need as well.
On a bar chart, I tend to think of the (weekly) prices within the box as a set of toothpicks. Each individual toothpick can and should be of various sizes. However, once a box has been identified we can draw two horizontal lines: one for the resistance at the top (located at the upper price for the box) and one for the support at the bottom (located at the lower price for the box).