The Nicolas Darvas Box Method is a celebrated trading strategy that combines technical analysis with disciplined risk management to capture trends in the stock market.
Originally developed by Nicolas Darvas, a professional dancer who became a stock trading legend, this strategy focuses on momentum, seeking stocks that are breaking out of defined ranges or “boxes.”
In this guide, we’ll dive deeply into the Darvas Box Method, providing step-by-step instructions on how to screen for stocks, identify entry and exit points, and manage risk using a modern twist inspired by Kristjan Qullamaggie’s use of the exponential moving average (EMA) for exits.
Understanding the Darvas Box Theory
The Darvas Box Method centers around identifying price ranges where a stock consolidates, then entering trades when the price breaks out of those ranges. The fundamental concept is that stocks in momentum often continue to trend upward after breaking out of consolidation zones. When combined with effective screening, entry/exit discipline, and a clear exit plan, the Darvas Box Method can be a powerful approach to trend trading.
1. Stock Screening for the Darvas Box Method
Finding the right stocks is a critical component of the Darvas Box strategy. A targeted screening approach is essential for identifying stocks showing signs of strength and potential upward momentum.
Key Screening Criteria
1. Price Momentum:
• Look for stocks making 52-week highs or reaching new all-time highs. Momentum is crucial in the Darvas Box Method, as the strategy is based on stocks continuing to push higher.
• Set your screener to identify stocks trading near the upper end of their range over the past three months.
2. Volume Surge:
• Higher-than-average volume during the breakout signals strong buying interest and institutional involvement.
• Filter for stocks where the recent volume is 1.5x to 2x higher than the average volume over the last 20 days.
3. Relative Strength:
• Use a relative strength indicator (RSI) to prioritize stocks outperforming the broader market. Look for RSI values above 60, indicating strength.
• Stocks with high relative strength are more likely to continue trending upward after breaking out.
4. Sector and Industry Analysis:
• Momentum often clusters within specific sectors or industries. Analyzing which sectors are leading the market can improve the probability of finding stronger trades.
• Prioritize sectors or industries showing consistent performance, such as technology, healthcare, or green energy.
5. Technical Filters:
• Consider adding filters for stocks above their 50-day and 200-day moving averages, as this alignment suggests a strong, established trend.
• Some traders also add filters based on the average true range (ATR) to focus on stocks with sufficient volatility.
2. Building the Darvas Box: Setting Up Entries
Once you’ve screened for potential candidates, the next step is defining the “box” for each stock. This box sets the stage for clear, actionable entry points based on price action.
Steps to Define the Darvas Box:
1. Identify the High (Top of the Box):
• Look for the highest price reached by the stock in recent days where it has faced resistance, failing to move higher. This level forms the top boundary of the box.
• Ideally, the stock should hit this level multiple times, reinforcing its significance as a resistance point.
2. Set the Bottom (Support Level):
• Identify a recent support level where the stock has repeatedly bounced upward, creating a floor. This forms the bottom boundary of the box.
• The range between this support and resistance level is your Darvas box.
3. Wait for Consolidation:
• To confirm a Darvas box, the stock should trade between these high and low levels for several days without breaking out. This consolidation phase indicates balance between buyers and sellers.
Entry Criteria:
The Darvas Box Method suggests entering a position when the stock breaks above the top of the box. This breakout signals a potential upward trend, as the stock is breaking out of consolidation.
Entry Steps:
• Set a Buy Order Above the Box High: Place a buy order slightly above the box’s top boundary to confirm the breakout is genuine.
• Volume Confirmation: Check that volume is above average during the breakout, signaling strong buying interest.
• Avoid Premature Entries: Do not enter if the breakout occurs with weak volume or if the stock appears overextended. The goal is to enter trades that show strong momentum with confirmation.
3. Exit Strategy: Using the 10 or 20 EMA
While Darvas initially suggested setting a stop-loss below the bottom of the box, modern traders often prefer using dynamic exit strategies, such as EMAs, to ride the trend longer while reducing the chances of getting stopped out prematurely. Kristjan Qullamaggie, a well-known trader, popularized the use of EMAs for this purpose.
Exit Criteria with EMAs:
• Trailing Stop with the 10 or 20 EMA: Instead of exiting at the first sign of a retracement, use the 10 or 20 EMA as a trailing stop. This keeps you in the trade as long as the stock’s momentum remains intact.
• 10 EMA: Ideal for higher momentum stocks with faster price action. This will keep you close to the price, allowing you to capture rapid moves while exiting before significant pullbacks.
• 20 EMA: Suitable for stocks with steadier trends. This approach provides a bit more flexibility and allows the stock to breathe, keeping you in the trade longer during moderate pullbacks.
• Exit Signal: Sell the position when the stock closes below your chosen EMA. A close below the 10 or 20 EMA indicates weakening momentum and potential trend reversal.
Advantages of EMA-Based Exits:
1. Trend-Following: The EMA exit strategy allows you to stay in trades longer, capturing the full extent of the trend.
2. Reduces Premature Exits: Instead of exiting at minor dips, EMA exits ensure you only exit on a more substantial trend shift.
3. Flexible for Different Momentum Levels: The 10 or 20 EMA can be adjusted based on the stock’s momentum and volatility, making it a versatile tool.
4. Risk Management: Protecting Capital
Risk management is crucial in the Darvas Box Method. This strategy involves setting strict stop-losses and ensuring position sizing aligns with your risk tolerance.
Risk Management Steps:
• Position Sizing: Limit each trade to a 1-2% risk of your total capital, ensuring no single loss can significantly impact your portfolio.
• Initial Stop-Loss: Place an initial stop-loss just below the box’s low to limit downside if the breakout fails. This keeps losses small if the trade does not work out.
• Adjusting the Stop-Loss with the EMA: As the stock rises, adjust your stop-loss to follow the 10 or 20 EMA, effectively locking in gains while allowing for trend continuation.
• Diversification: Avoid putting all your capital into one stock or sector. Hold positions in several stocks to reduce the impact of an unexpected price reversal.
5. Tools for Effective Darvas Box Trading
To effectively apply the Darvas Box Method, consider using trading platforms with advanced charting and alert systems:
• Price Alerts: Set alerts for when stocks break above or fall below specific levels (e.g., the top of the box or EMAs).
• EMA Indicators: Enable the 10 and 20 EMAs on your charts for easy tracking of exits.
• Volume Indicators: Volume analysis is crucial for breakout confirmation, so ensure volume indicators are clearly visible.
Final Thoughts
The Darvas Box Method is a classic strategy that, when adapted with modern techniques like EMA-based exits, can become a powerful approach for trading in momentum-driven markets. By carefully screening for stocks with strong fundamentals and momentum, establishing disciplined entries, and using a dynamic EMA exit strategy, you can maximize your potential for capturing trends.
Use this approach with patience and discipline, and you’ll position yourself for success in today’s fast-moving markets.