Applying Nicholas Darvas' Box Theory to Today's Stock Market

By: Michael Swanson | Mon, Oct 20, 2008
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Is the market going up or down? That is the question everyone wants to answer right now. They want to know if their losses are going to come to an end. People are incredibly anxious and nervous right now. I know, because I realized last week that they were making me nervous even though I have been in cash for weeks now.

Over the past few weeks my phone has been ringing nonstop from people that know me locally and are desperate about the market and what it is doing to their retirement accounts. These aren't sophisticated investors for the most part, but just people who know me socially. They were calling me on the phone wanting to know what to do about their falling 401K's and retirement accounts.

Their nervous energy made me nervous and I've come to realize that there is nothing I can do to fix their anxiety. I told many of these people we were going into a bear market a year ago and not one of them listened. I cannot tell them what to do now, because I have no desire to take responsibility for their money. If I tell them to sell and the market goes up they'll get mad. And if I thought they should sell and told them to do so they probably wouldn't anyway so there is no point in trying to tell them what to do.

All I can do is tell people what I'm doing.

And I've been a shorter in this market at times in the past year and am now totally in cash, waiting for a good risk/reward opportunity in the market.

I realized though that the anxiety these people had rubbed off on me a little bit and I had to get away from them and regroup and focus on what is important in the stock market.

Most people don't analyze the market at all. They just throw money at it and hope. They think that is what investing is about and then when they lose money they blame it on manipulators. They blame others for their losses instead of taking responsibility for their own money. The days of easy money are over. You aren't going to be able to buy a house and double your money in three years or buy just any stock and have it go up. Not in the worst bear market ever so far.

Because people don't know anything about trading or how to read the market, massive anxiety and panic is hitting investors across the United States, and probably the world for that part. Americans are getting almost as uncomfortable as they were after 9/11. Bush used that anxiety to get Americans to agree to the war in Iraq without thinking at all and now the next President will probably use the anxiety to push through who knows what type of economic "programs" and bailout operations.

After 9/11 Americans just obeyed Bush and hoped he would make everything right again. Just as the terrorist attacks were going on the US economy went into a recession so much of the anxieties of the time were really about that - they were just transposed on to terrorism and Saddam Hussein. People felt uncomfortable to see the US get attacked and the stock market fall and they wanted to be protected. Bush gave them that script. He believed it himself.

Who knows what the next President will do. The masses are easy to manipulate, because they simply follow the herd and take no responsibility for themselves. They allow others to tell them what to think and what to do. That's why so many sit on their mutual funds in bear markets - CNBC and Wall Street tell them to do it so they do it. They are either too lazy to learn about the financial markets and how to be a successful investor or simply lack the self-esteem and confidence to believe they can learn. So they sit there and obey and become gullabulls for Wall Street.

But you have to take responsibility for your money if you want to make money in the stock market. You have to learn about market trends and know when the market is going into a bear or bull market.

Instead of being all anxious about the market right now you need to be in a position in which you can answer the question is the market going to go up or down? - and more importantly you have to have a strategy that you can apply to the market to give you low risk/high reward opportunities no matter if you are a short-term daytrader or a long-term investor.

Right now I'm simply in cash waiting for the opportunities to line up that the market will eventually give me. That is the most important thing to do to make money in the financial markets and I don't even need to answer the question "is the market going up or down?" to do that. I just have to wait for them to come.

And when you do that you can approach the markets with confidence instead of anxiety. When it comes to analyzing the market and what it is doing right now using technical analysis the answer is simple - the stock market is trapped in a box.

Nicolas Darvas coined the idea of "box theory" in his 1960 book How I Made $2,000,000 In the Stock Market. Darvas was trained as an economist in the University of Budapest, but escaped the Nazi war machine and spent the rest of his life on a dance team that became on of the most successful acts in Europe and the United States.

Nicholas Darvas Box Theory

In his spare time he read some 200 books on trading and speculation and tried out different trading methodologies until he found one that worked for him. He found that stocks that went to new 52-week highs tended to go higher. Darvas considered stock prices as a series of boxes. When the price stayed trapped in a box he waited. When the price then rose out of the box he would buy and then he would simultaneously set a stop-loss order under the box.

He used his brain to study the markets, come up with a strategy that worked for him, and then developed risk/reward principles to manage his trades.

His "box theory" has been a clear influence on the popular investment books of today, such as William O'Neill's works.

This basic technique is the first successful trading strategy I ever used. I applied it in the late 1990's with tech stocks, but at the moment I'm not using it, because we are in a bear market.

But it is still a useful way to look at the markets - especially when looking at the short-term trend right now.

It gives us a clear way to understand the huge day to day swings going on in the market right now.

Applying the Box Theory to Today's Market

The stock market is clearly trapped in a box with support at 850 and resistance below 1050 on the S&P 500. This is a big box and that is why the market has been swinging with such huge volatility in the past few weeks. This box represents either a pause before it goes lower or a short-term transition phase for the market as it builds a bottom to rally off of.

Box theory doesn't tell us whether or not the market is going to go up or down, but it tells us what is happening and that can be just as important. If the S&P 500 closes below 850 then it is going to have another leg down. If it can continue to build a base above 850 and then break out of the box by closing above 1050 then it will rally - most likely into the end of the year.

Now here is the thing. If it is going to break out of the box it is going to have to consolidate further and usually during the end of such consolidation periods volatility actually shrinks, causing indicators such as the bollinger bands to come together. That actually brings a good risk/reward entry point on the long side that allows you to buy - before the market breaks out of the box. It would take a least another week of consolidation for this pattern to come together.

However, one must be prepared for the possibility of the market falling again. Back in September the market formed a box then and broke lower after the passage of the bailout bill. People got all focused on the wild gyrations and the news around them and didn't see what the market was doing - that it was basically trapped in a box that merely represented a pause in a bigger downtrend.

There is no need to be nervous about the market if you understand what it is doing.

An even bigger question is "if the market bottoms here is it the end of the bear market?"

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Michael Swanson

Author: Michael Swanson

Michael Swanson,
WallStreetWindow.com

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