You may or may not have heard of Nicolas Darvas, the legendary dancer-turned-investor who made two million dollars in the stock market in the days when that was a whole lot of money -- and wrote a book on how he did it. In this article I'll go through who he was, how he bought and sold his shares, and how his ultimately successful strategy was based on a "box theory" of how share prices move. I'll also offer a concrete example of his box theory in action, via an example chart that presented itself to me recently.
Darvas, the dancer
Nicolas Darvas emigrated to America in 1951 and trained with his half-sister to become a ballroom dancer. Although they became a highly successful worldwide touring act, this doesn't sound like the ideal background for an equally highly successful investing career. So maybe I should mention that, before emigrating to America, Darvas had studied economics at the University of Budapest.
Darvas, the gambler
Having been offered shares of a particular stock in lieu of payment by a couple of nightclub owners, and having then made a tidy profit on the stock, Darvas got the stock market bug and started asking around for more "stock tips". By his own admission, he was merely gambling, and his shrinking portfolio reflected that fact.
Darvas, the fundamentalist
Darvas signed up with a broker in New York and began regarding the brokers' suggestions as merely "information" rather than "tips", and he began taking a fundamentalist approach to assessing stocks based on factors such as the price-to-earnings ratio. Yet he still lost money, and faced bankruptcy.
Darvas, the technician
Darvas saved his own skin by investing in a stock -- TEXAS GULF PRODUCING -- for which he knew nothing about the fundamentals. All he knew was that its price was rising day after day. This marked the beginning of his time as a technical investor, focused on buying the right stocks at the right time with a view to making small losses and big profits. His chief weapons in this endeavour would be price and volume, the box theory (illustrated later), implemented using automatic buy orders and stop-loss sell orders.
Darvas, the techno-fundamentalist
Having noticed that most stocks go up in a bull market (but some more than others) and that most stocks go down in a bear market (but some less than others), Darvas concluded that what distinguished the good stocks and the bad stocks was their earnings. Thus, he settled on a techo-fundamentalist approach in which he would select stocks on their technical (price) action in the market, but only if he could give "improving earning power" as a fundamental reason for investing.
To cut a long story short, this ultimately led to Nicolas Darvas making his fortune and publishing his book How I Made £2 Million in the Stock Market.
Darvas and his amazing box theory
Although Darvas ultimately became a techno-fundamentalist, the major part of his approach was technical and based around the "box theory" that he had developed about how stock prices move. The best way to begin describing the theory is in terms of price support and resistance and the observation that, once broken, a previous resistance level (above which the price usually will not rise) often becomes a new support level (below which the price will usually not fall). I've illustrated this phenomenon in the following chart.
Since this is a purely technical chart phenomenon, it should be applicable to any stock, and so it wouldn't help the illustration if I told you which company this is. (But don't forget that Darvas incorporated another "fundamental factor" into his overall theory of what to buy and when to buy it.)
Darvas visualised that stocks would trade within a particular range before jumping into a higher or lower range, as indicated by his "boxes", which might look something like this:
His approach would be to buy a stock when the price moved into a new box, which is what we would nowadays commonly refer to as "buying on a breakout".
While studying these boxes, notice how sometimes they might overlap, when the combined support/resistance level becomes less certain. My own theory is that this phenomenon could mark the later stages of the beneficial price trend.
Foolish bottom line
Although the major part of the Darvas method, ie his "box theory", was technical rather than fundamental, we should not forget that he settled on a techno-fundamentalist approach that further qualified his potential investments according to company earnings.
Nicolas Darvas certainly "boxed clever" in the stock market, and his theory proved its worth by making him rich. Whether it will work as well these days is anybody's guess; but my example suggests that there might -- just might -- be something in it.
By Tony Loton
Additional Reading Please click the following link.
Nicolas Darvas Trading Secrets