The most important thing about trading the winning method of Nicolas Darvas is to achieve an understanding of what he called Darvas Boxes.
What are Darvas Boxes
Darvas Boxes are simply a time in a stocks trading lifetime when they have retraced from a new high back down to a level of support that is not too far in price and time from its recent high.
However, what must be taken into account is that the new high must be a significant new high. By this we mean that the stock has broken away from an established sideways trading range and by undergoing a defined time of increased buying, that can be seen by and increase in the stocks volume, has reached a new high for the last year (365 days).
Once this stage of increased buying has taken the stock to it’s new high, selling will start by traders and institutions who wish to take a short term profit, and the price of the stock will start to fall. This is an important time in recognizing the formation of the Darvas Box. If the price falls to far and maybe looks like it could return to its initial trading range then a false breakout has occurred and there is no Darvas Box. However, if the stock stops falling after 3 days, then the lowest trading price should be noted and marked as the bottom of the Darvas Box and the recent high should be noted as the top of the Darvas Box.
Why do Darvas Boxes Happen?
This is an interesting question that probably has many answers. The truth is however, that we should not be in the least bit concerned how Darvas Boxes are formed since we have studied the methods of How I Made $2,000,000 in the Stock Market and Wall Street - The other Las Vagas, and we know that reasons for price fluctuations in the stock market are something we can not control and never have no need to worry about. All that matters is that the stock has shown a build up in volume and the price has risen to a new high. If the Darvas Box fails, our stop loss is hit and we are no longer concerned about the stock.
But sometimes it is still nice just to know. Well I can’t tell you. Sorry. I just don’t know. But here is one reason why I believe it happens (but don’t take my word for it):
A company is trundling along doing nicely. It has positive cashflow, is able to pay the employees at the end of the month, and has a smart management team who are creating great plans for growth. The directors and managers all have faith in the company. Not many others are aware of this or are paying attention. Because the people who do pay attention have an idea that the company could achieve great growth, they believe that in a years time the stock will be worth a great deal more than it is now. Because they are smart and have a plan, they go ahead and start purchasing stock and thus the trading activity increases as shown by the jump in volume. Also, because the directors and management are fairly well off, they start to buy large over a period of time. To begin they buy from the people who just want to get rid of the stock. Once all of these people have sold, next they buy from the people who are prepared to sell when the price is a little higher. So the price of the stock rises. As it rises more people start buying. This gets repeated until a point not long after the 52 week breakout, that some of the buyers offload some of their stock to the other buyers, and the price starts to fall.
This is the crucial point of whether the Darvas Box appears. If more people believe the stock is worth more, than the amount of people who actually now have changed their minds and believe that it is a lemon, then stock will only fall for a few days before levelling out and starting to rise again. And this is where all the people in the world who scan stocks for Darvas Boxes or a myriad of other technical indicators such as Moving Averages, Momentum, Confirmed Breakouts - all jump in and start buying a few shares. So the stock rises again. If it reaches a new high, then the chances are that the only way it will start falling is if something happens that truly shakes up investor confidence - such as war, avian bird flu, terrorism, foot and mouth disease, or news that un-equivocably confirms that the stock is actually a lemon beyond all shadow of a doubt.
So there you go - that is one reason why I reckon Darvas Boxes appear on stock charts. But like I said, it does not really matter because all we are concerned is that the stock is rising and if it doesn’t, then our stop loss will prevent us from losing the farm.