The box theory is a trading tool used to identify stocks and other financial assets poised for significant price swings. The box theory uses the asset's price history and looks for the formation of a box on the price graph. Like all other stock picking tools, the box theory should not be used in isolation. However, when used as part of a comprehensive analysis, it can be a valuable tool for the investor.
When selecting a specific stock for investment, you can use either fundamental analysis or technical analysis. Fundamental analysis involves the company's financial data, such as sales, profits and receivables. Technical analysis, on the other hand, uses stock price and volume data. By using such tools as lines, triangles and channels, the technical analyst tries to forecast future price movements based on past price history. More advanced technical tools include statistical calculations, such as moving averages of past prices, as well as volume data. While technical analysis is most commonly used for stocks, it can be used for any asset with a price and volume history.
Box Theory Definition
Developed in the 1950s by Nicolas Darvas, the box theory is a specific technical analysis tools that involves searching for a box on the stock's price chart. When the criteria established by Darvas for the formation of a box are satisfied, the analyst will begin to closely monitor the stock for a breakout. Until such breakout occurs, the stock will be considered "boxed in," which denotes an inability for the stock's price to break the top or bottom lines of the box. Once this breakout occurs, the stock is expected to advance or decline significantly, generating a buy or sell signal.
Identifying the Box
To identify the top line of the box, the analyst checks the 52-week high, which is the highest price recorded during the past 52 weeks. When a stock advances beyond the 52-week high and then falls, establishing a new 52-week high, or when the price stagnates at this new high without rising above it for three consecutive days, a new top is set and the analyst redraws the lines. Likewise, the 52-week low represents the bottom or floor of the box and is re-established when a new low is set or when the price lingers at that level for three consecutive days without dipping below it.
If the stock price goes above the top of the box or dips below the floor, it is said to have broken out of the box. This is a key signal, as it signifies that buyers are willing to pay more than the previously established highest price or sellers are willing to accept less than the prior lowest price. A breakout to the top generates a buy signal, while a breakout to the bottom generates a sell signal. If such a breakout occurs on days with high trading volume, the signal is considered more reliable.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.