Sunday, 27 April 2014

Nicolas Darvas And His Amazing "Box Theory"

The techno-fundamentalist who made millions.

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.

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Quote for the day

“The best fertilizer is the farmer’s shadow. This adage applies equally well to trading as it does to farming. Trading profits are cultivated in the rich soil of market discipline, strict money management and consistent adherance to a proven trading strategy.” – Howard Abell