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Day Trading

Trading Stock Options With Darvas Box Theory

Nicolas Darvas was a dancer who invented a trading system while traveling the world, and made over $2,000,000 in about 18 months. Keep in mind: this was in the late 1950’s! In today’s dollars (at 5% annual compounding), he made over $20,000,000. That system, the Darvas box theory, relies on a very simple technical analysis idea.

The Darvas Box Theory

A Darvas box is an area of price consolidation wherein the stock treads over a long period of time. For example, imagine a set of toothpicks lined up in a row. Now, each toothpick is a different length, and represents the trading range for the stock in any given week. The idea behind the Darvas box is that when we line up all these toothpicks, we can easily draw a horizontal line at the top and the bottom of the toothpicks, which represents the support and resistance lines. Darvas’ premise is that when the stock breaks out above the top of the box, it triggered a buying opportunity.

Note that the Darvas method is not a day trading system. While it may be possible to use it as such, Darvas himself used weekly charts.

Why Use Stock Options

The beauty behind buying stock options is the limited risk and the leverage. The risk is limited only to the amount put into buying the options (that’s the obvious part). The not so obvious part is the leverage. When we buy an options contract, we are buying the right to control 100 shares of whatever stock the option is written on. In most cases, it costs much, much less money to hold the contract that the equivalent 100 shares. For example, 100 shares of Decker’s Outdoor would cost us almost $16,000 as of this writing. However, an at the money call option would only cost us $2,100. Yes that’s still a lot of money, but it’s only 1/8th of what we would have to pay otherwise.

Trading the Box Theory with Options

When Darvas was trading stocks, options were not available (options were not publicly traded until the 1970’s). In today’s world of financial innovation, we as investors can do almost anything so long as we are willing to pay. Such is the case with the Darvas method. With stock options, we can buy the right to profit from both sides of the stock movement by using the options strategy called a Straddle.

In a straddle, we buy a call and a put on the same underlying stock at the same strike price with the same expiration date. That way, it doesn’t really matter what the stock does. So long as it moves a lot in either direction during the period that the option is alive, we will make money.

One thing most people don’t think of when you buy a straddle: Once one leg is in the money and profitable, you can sell it and keep the other leg. That way, if the stock reverses course your worthless option is suddenly making you money again.