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Darvas Box Trading Lesson 4

/Darvas Box Trading Lesson 4

Calculating the Breakeven Level

 

The breakeven level is easily calculated, but some traders make the simple mistake of not including all the costs incurred in the trade.

It is essential that both the entry and exit brokerage fees are included in the cost. The total cost for the trade is then:

 

Total trade cost = (Parcel size * stock price) + entry brokerage + exit brokerage.

 

For example suppose we wish to enter a trade at a price level of $1.00 with entry and exit brokerage of $60.

 

If our parcel size is 500 we have a total cost of: (500 * $1.00) + $120 = $620

 

Optimising the Breakeven Level

 

The task of optimising the breakeven price level is achieved by finding a minimum breakeven level for the trade. Given that the brokerage costs and the stock price may be taken as fixed for entry to the trade, the breakeven level may only be optimised by carefully adjusting the parcel size

The breakeven level is calculated by dividing the total cost by the parcel size:

 

Breakeven level = $1120/1000 = $1.12

 

The stock must at least reach this level before we achieve a no loss situation. Any exit price below this level will result in a losing trade. If we increase the parcel size to 1500 shares the total cost is now:

 

Total cost = (1500 * $1.00) + $120 = $1620

 

The breakeven level is now:

 

Breakeven level = $1620/1500 = $1.08

 

Similarly for 2000 shares the breakeven price is:

 

Breakeven level = $2120/2000 = $1.06

 

As can be seen from the preceding examples, an increase in the parcel size results in a lower breakeven level. We reach a profitable level sooner the bigger the parcel size. However, the trade off is an increase in capital required to fund the trade and a greater capital risk level within the trade. Care must be taken to balance this risk and optimum parcel size for the trade. All of these parameters must take into account our trading rules regarding permitted capital risk per trade and of course the size of our trading account.

 

A common mistake made by novice traders in the rush to complete their first trade, is to buy a small parcel of “penny dreadful” shares with no realistic possibility of even covering brokerage costs let alone reaching a breakeven level!

 

Analysing the Trade

Now that we have optimised the parcel size with the maximum size permitted by our trading rules and the limits of our trading account, we are now in a position to estimate the likely success of the trade. We should now stop and ask ourselves some questions such as:

 

After analysing the past performance of the stock, does a

significant rise beyond the breakeven level seem possible?

Is this a realistic possibility or are we merely gambling on an

unlikely event?

 

Taking the time to do this simple homework will prevent us entering unrealistic or potentially unprofitable trades.

 

Managing a successful trade is a balance between good risk management and good money management. A common error is to attempt to reduce the trading cost by using cheaper broking services such as online brokers, but this is a foolish economy. The benefits provided by broking services offering stop loss facilities far outweigh the higher brokerage cost. A better strategy is to employ the simple money management technique outlined and optimise the trade.

 

Placing Your Order

 

Once you have found a stock that has formed a Darvas box and your breakeven analysis deems it a viable trade, what next? The

Darvas box provides you with a graphical trading plan, an entry level, an exit level, and a risk level. Your first actions should be to place an order to purchase the stock once the stock trades at a price just above the price at the box top and at the same time place an initial stoploss to exit the trade when the stock trades at a price just below the price at the bottom of the box.

 

Do NOT wait for a break of the box top before placing your order. Buying after the break of a box is folly as you are reacting to the market, not pre-empting it. You will find yourself chasing the stock price and enter at a much higher level than necessary.

 

Do NOT buy when the stock has not yet penetrated the box top.

 

A comment often made is “If I’m going to buy the stock, why not get it at a cheaper price before it breaks the box top?” The answer is that only the break of the box proves that the stock is a worthwhile trade. Before the break it is only a possible candidate. It could just as easily drop in price; remember we only want stocks that are going up.

 

 Managing Your Trade

 

A key aspect of Darvas’ trades was his use of a trailing stoploss to manage his trading risk. Using extremely tight stops, Darvas minimised his capital losses. However, this strategy meant he would “stop out” of more trades. He was willing to accept the possibility of brokerage losses rather than expose an unacceptable level of his trading capital to the market. When trading like Darvas we must accept this risk also.

 

Let us assume that we are now engaged in a trade. We’ve placed our order and an initial stop-loss. The stock price has broken through the box top and our order is executed. What next? All we can do now is adjust the stop-loss level. This is done with the caveat that we may NEVER lower the stop-loss level, so all we may do is move it up. Where we move it to is the issue and this is determined by the price movement.

If, as in Figure 6, the stock moves weakly out of the box top without making strong, definite gains, a strategy may be to trail our stop up so as to maintain our maximum risk level. If our initial risk level was 10%, we move our stop up so as to maintain this maximum risk level. Remember, this was the risk level that was acceptable when we formed our trading plan, so we should stick to our plan and maintain this maximum risk level. Our aim is to get our stop-loss up to, and hopefully beyond our breakeven point. Once the stop reaches the breakeven point we have a no-lose trade. Always remember that once the price starts to move upwards, if we don’t move our stop-loss up also, we are increasing our risk level. All positive price movement is not just changing numbers, it is your money.

If the price rises and you don’t move your stop, you are exposing more and more of your capital to the market.

For stock with what I call the “Darvas Signature” we adopt a different approach. We see an example in Figure 7. In this case on the strong breakaway from the box top, we move our stop up to just below the box top. When another box forms we move our stop up to just below the bottom of the new box, waiting for a break of the new box top. When the break occurs, we move our stop again up to just below the box top. If a box does not form quickly as in the third box in our example, don’t be afraid to trail your stop up outside the box, remember we are trying to lock in profits.

 

Pyramiding the Position

 

Pyramiding the position is a part of Darvas trading that at first may appear unusual. Traditionally we are taught to diversify our investments to dilute our risk. We may have some high performing stocks, and some stocks that are poor performers, but everything should average out in the long run. In my opinion this is nonsense.

 

What we are doing is attempting to reduce risk by accepting mediocre performance. With the risk management provided by the trailing stop, we are refusing to accept poor performance since we will “stop out” of these trades. The stop-loss and market movement will combine to “separate the wheat from the chaff.” Darvas’ philosophy was to only accept minimal losses. However, when he had a winning trade, he would focus his financial resources, not diversify them in order to maximise his profits.

 

In Figure 8 we see our plan would be to buy a break of $2.59 with an initial stop-loss set at $2.45. Upon the break of the first box we would quickly trail our stop-loss up to just below the box top at about $2.58. On the formation of the new box, we trail our stop up to $2.64, and place an order to buy another parcel of this stock on a break of $2.93. If it never breaks the $2.93 level, we never buy the new parcel of shares. If it does it means the stock is making new high prices so we are attempting to concentrate more of our financial resources into a rising stock. A point to remember however is that if we wish to use the pyramiding technique we must do our homework in terms of breakeven analysis for each individual box trade.

 

Will it Work in Today’s Market?

 

The first common comment we encounter is

 

“The market is far more volatile today, Darvas did not have

today’s volatility to contend with.”

 

While there is undoubtedly more volatility in today’s markets, the methods that Darvas used to define his boxes incorporated the volatility of the day, making his method applicable then, now and in the future.

 

“Darvas was fortunate that he was trading during an era of great

change, the space race was on and the computer age was about to

begin.”

 

The facts are that there is always a “new” era of change about to dawn on us. Technology is always advancing. We feel that the Internet has a long way to go, as do most forms of communication, but the real advances have yet to come in the area of health, biotechnology, waste disposal and genetically modified food just to name a few possibilities.

 

“Darvas was lucky, he made most of his money in a bull market.”

 

As with most people, the harder Darvas worked the “luckier” he got. The bull market was almost incidental. He would have made his fortune anyway. It may have taken him longer if the bull market did not come along. The real issue here is that Darvas kept his fortune at the end of the bull market because his unique trailing stop loss method had him out of stocks when the market duly crashed.

 

It is my opinion that with modern software packages, that Darvas trading is as valid today as it was over 40 years ago, perhaps even more so. Good risk management and trade planning will always be at the heart of successful trading. As an experienced trader I can’t but marvel at the discipline and self-analysis that made Darvas such an exemplary trader. Since discovering Darvas, my first scan every day is for Darvas boxes. I hope you embrace Darvas’ techniques as I have, I am sure it will be of great benefit in your trading endeavours.

 

Good luck and good trading!

 

Frank Watkins