With all the tools and technology we have to help navigate the market’s treacherous waters, profitability is still frustratingly elusive for most traders. Even with 24-hour access to the markets, around-the-clock financial news, online brokerages, the ability to buy/sell stocks at the touch of a smartphone app and new indicators being released all the time, traders still struggle. The goal of growing your account to become wealthy—to maybe move to full-time trading—seems sound and reasonable in theory, but in reality it’s out of reach for most. You may find yourself playing a frustrating game of “win a little/lose a little more” combined with frequent bouts of breathtaking success and followed by crushing losses.
With all the technological advantages offered today, you have to ask why traders fail to achieve consistent results.
Studying the market’s past price behavior can help you find common themes or patterns that you can use to make better trading decisions. In the same way, looking into the past for individuals who achieved the results that you desire may hold the key to success. You may seek someone like you: Someone who isn’t a Wall Street insider or has a seat on a stock exchange, someone from the unlikeliest of places who succeeded beyond his wildest expectations.
A prodigy emerges
Nicolas Darvas managed to get out of Hungary just as the Nazis began to take over Europe. By the 1950s, he and his sister were one-half of one of the highest paid dancing teams in the United States.
One day, a couple of club owners offered to pay him in stock if he would come and perform at their nightclub. They offered him $3,000 worth of shares in a Canadian mining company for a performance at one of their clubs in Toronto. The date fell through, but he offered to buy the stock from the owners anyway to prevent any hard feelings.
Forgetting about the stock for a couple of months, Darvas checked back on his investment and found that he had made more than $8,000. Elated at his windfall, and despite this initial profit being based entirely on luck, it sparked a lifelong fascination with the stock market.
Unfortunately, following this initial success, Darvas spiraled into a long series of losses by committing every mistake a beginning trader could make: Asking for tips, listening to the advice of so-called experts and buying whatever the current hot issue was.
As a result, losses mounted and grew larger over time.
The Alexandrian solution
Alexander the Great, before he ruled Asia, learned of the challenge of the Gordian Knot. The Gordian Knot was said to be a massive knot of complicated twists and turns that was unsolvable. So far, it had baffled all comers, leaving them both puzzled and frustrated at being incapable of unfastening it. However, if Alexander could manage to undo the knot, then the city agreed to declare him king and he could add another kingdom to his growing empire without shedding blood.
After studying the knot carefully, Alexander raised his sword and sliced powerfully down at the knot, cutting it into two massive pieces and undoing it. In one swift move, he undid Gordian’s Knot and won a new kingdom for his empire without having to go to war.
This simple, direct action became known as the “Alexandrian Solution.”
For Darvas, the early losses he experienced proved to be a fertile field of lessons and spurred him on to find his own Alexandrian Solution.
He began studying his winners and losers closely and realized that tips from others and trading from the hip often led to serious losses, while his winning trades revealed certain clues. These clues became the foundation of a new method of trading that would go on to turn $36,000 into more than $2 million inside of three years.
Box trading theory
Darvas began to piece together the puzzle of a new trading method that could identify winning stock moves that became the cornerstone to his future success:
- The fundamental analysis of the stock is promising.
- The stock makes a new high.
- Enter the stock as price trades through its all-time price level.
- As the stock is trading up through its previous high, volume is surging.
Darvas used this method to make $2 million in the markets despite maintaining a full schedule of dancing tours in Europe. He didn’t need to follow the market ticker constantly, sending trading instructions to his broker in the United States via Western Union. This same setup is effective in the stock market today (see “Darvas setup,” below).
Still, there were some gaps in his method that presented dilemmas for those who tried to follow in his footsteps. One, Darvas never made a distinction between a 52-week price high and an all-time price high. Two, he never used any other technical methods (which weren’t necessarily available at the time) to refine his method, which created situational risk.
While a 52-week price high produces more trades than the all-time price high, it is less likely to run into any overhead resistance. When a stock’s price declines, it will form a steady series of lower price highs followed by lower price lows. It’s at these price points that investors are buying because of a belief that the stock is undervalued. If the stock continues to decline, then these investors face a difficult choice: Sell or hold. Often, they choose to hang on hoping to break even, and it’s at these price points where overhead resistance is formed. If the stock trades back to these price levels, then these investors start selling. This can derail the stock’s trend or stall it by making price action trade sideways (see “Overhead resistance,” below).
Using the all-time price high offers fewer trades, but without any overhead resistance to cause this kind of problem.
The other gap in Darvas’ method is that technical indicators weren’t available during his time. This wasn’t his fault, but nevertheless is potentially a powerful enhancement of his approach. What if Darvas had the ability to identify the right amount of volume to time his entries? Or what if he could have used moving averages to filter mediocre trades from winning trades with greater volume?
With today’s tools, perhaps Darvas could have achieved even greater results.
Filling in the gaps
A modified approach is proposed. The new Darvas box trading 2.0 method combines what worked in the past with today’s tools to help refine the setup conditions and the trigger for the trade.
This Darvas box trading 2.0 setup is long-only as detailed below:
- Use the 20-day and 50-day simple moving averages (SMAs) on the daily chart.
- Price is trading within 10% of an all-time high and above the 20-day and 50-day SMAs.
- Price stays within this 10% range for a minimum of three weeks.
- Support and resistance are established, forming a rectangle or box-like price pattern.
- Trade up through resistance on greater than 30-day average volume.
- Price closes above the previous price high.
- Enter on the opening of the following trading day.
Adding the SMAs acts as a filter to keep you in stocks that are trending higher and out of stocks whose price action is weak. Also, your entries are better timed by having a specific level of volume at the time of your entry to establish the quality of the breakout to the upside (see “Box entry,” below).
Darvas focused greatly on price action during his trading days, but he also focused on finding potential stock candidates where the market was showing the greatest strength. He had coined the term “techno-fundamentalist,” meaning that while he looked for strong fundamentals in a stock, he based his decisions on whether to buy or sell on technicals.
In risk management, you always want to manage your position so you risk as little capital as possible. Darvas’ method called for moving your stop just below any new higher low established in a stock’s price action to trail the stop-loss point with a potential for capturing a runaway move. However, a good rule of thumb is to take profits at three times your initial risk and move your stop to break even on the other half. This style of trade management makes you some money in the short-term, while putting you in a position to win big at the same time.
There are times when you will see another Darvas box 2.0 setup occur after you enter a position. You can do one of two things: Adjust your stop just underneath the pattern’s support level to control risk, or you can pyramid and add to your position.
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