How the Darvas Box Method Can Help Today's Investors Stick With Winners

One of the pioneers of momentum trading and investing was Nicolas Darvas. His relatively-simple system became the basis for the CANSLIM investing approach popularized by William J. O’Neil of "Investor's Business Daily" and for many other trend-following systems.

Darvas was born in Budapest, Hungary in 1920. His family fled the Nazis during World War II and lost everything. Darvas moved to the United States and started working as a waiter in a restaurant before eventually finding success as a professional dancer. He toured the world with his dance partner and started dabbling in the stock market.

Like many other new investors, he had limited success and found that he had a tendency to hold on to losing stocks too long while taking profits in his best stocks too quickly. Over time, he noticed that the best stocks tended to have one common similarity: they would make a series of new highs. His mistake was being too anxious to score a victory by quickly locking in his gains when a stock broke out. Great stocks keep going higher, and it was necessary to devise a system that would help him stay in them.

Darvas developed a trading approach he called the "box method" to help him enter these stocks after a period of consolidation. The key to the system was to make an initial buy of a stock as it hit a new high. Most stocks will consolidate gains for a while in a box. Darvas would add to the position when they broke out of the box of consolidation and moved to a new high.

A very good example of how this system would work can be seen in Nvidia NVDA:

It is very easy to see after the fact that Nvidia is an exceptional stock, but what is important is that Darvas’ box system would have kept someone in the stock as it went on its wild rampage. There would likely be many other failed attempts to find strong momentum in other stocks, but the system would help keep losses fairly limited while offering the potential for substantial upside. Nvidia is important because it shows how the box system will reward an investor if and when they find the right stock.

The box system is the heart of the Darvas methodology, but Darvas considered several other factors when looking for the best stocks. First, he wanted positive market conditions. Even the best stocks will struggle in a bear market, so it is important that there be a positive overall trend. Darvas did not short stocks, so he was content to sit on the sidelines while looking for the right opportunities.

Darvas also felt it was very important to hold concentrated positions. At most, he would only hold five to eight names, and there were times when more than half of his account would be in a single stock. When he found a winner, he wanted to make the most of it and didn’t worry about diversifying to avoid risk.

Darvas knew that he would have numerous failed trades while looking for the big winners, so he would make pilot buys and use tight stops to limit losses. He utilized his boxes in various ways to set his stop-out levels.

When Darvas found a winner, he would build the position aggressively as it broke out from one box and started the development of another. He wanted to make the most of his winners rather than trying to immediately proclaim victory.

The are many other nuances to the Darvas box system. He was not a pure technician and would consider some fundamentals along with the price action. He also used a variety of rules for cutting losses and taking gains. The key was that he was very emotional about it and stuck to his rules.

The Darvas box system is important because it implements the most important rule in investing: Cut your losers quickly and let your winners run. That is very obvious advice, but Darvas found a way to implement it effectively and his system can help traders today.

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At the time of publication, DePorre had no positions in any securities mentioned