What Is Fair Value Gap (FVG) [Imbalance, Inefficiency in Trading 2023]?

Do you ever feel like the trading world is a puzzle with missing pieces? The pieces don’t fit together neatly in the dynamic realm of financial markets. But what if I told you there’s a trading strategy that can help you solve this puzzle? Imagine having a tool that not only identifies potential opportunities but also provides a roadmap for when to enter and exit the market. The Fair Value Gap Trading Strategy (FVG) is exactly that tool, so you’re in for an incredible experience.

Fair Value Gap (FVG) is a trading approach used to spot price variations in the market, which are indicated by distinct candlestick patterns and gaps in the price history on charts.

In this article, we will unlock the secrets of FVG, unveiling how it can empower you to trade with precision and confidence in an ever-changing market landscape. 

Key Takeaways

• Traders Not Hindered: Fair value gaps and liquidity voids in the market do not hinder traders. Instead, they create opportunities for traders to act and influence the market due to a need for more liquidity in those areas.
• No Impediment to Identification: Fair value gaps in trading patterns are easily identified. Traders can do so by analyzing the relationship between candle wicks and the body of the candles, revealing the presence or absence of liquidity voids.

What Is the Fair Value Gap (FVG)?

The Fair Value Gap (FVG) is a pivotal concept in price action trading, often referred to by various terms such as imbalance, inefficiency, or liquidity void. These terms describe the same concept. 

FVGs occur when large amounts of money change hands quickly and dramatically, either bullish or bearish. These changes cause market gaps, which are the basis of the FVG trading method.

Simply put, FVGs are predicated on the idea that markets have an inherent tendency to correct themselves. We call these market inefficiencies “FVGs,” which cannot be maintained for long. After a strong initial move, the market tends to retrace its steps and return to these levels.

Related Article: Mastering the MACD Indicator: A Comprehensive Guide for Traders

What Are the Two Types of Fair Value Gaps?

Let’s delve into the two distinct types of Fair Value Gaps (FVGs):

1- Undervalued FVGs

Undervalued FVGs represent a scenario where market prices are observed to be lower than their perceived fair value. This condition suggests that the asset or security trades at a discount, creating an opportunity for traders and investors. 

Historical data analysis often reveals instances where an asset’s market price significantly deviates below its intrinsic or fundamental value. This deviation can be quantified by assessing metrics such as Price-to-Earnings (P/E) ratios, Price-to-Book (P/B) ratios, and other fundamental indicators.

Traders and investors view Undervalued FVGs as buying opportunities. They anticipate the market will eventually recognize the asset’s worth, leading to price appreciation. Value investing is commonly employed in these scenarios, where investors aim to buy low and sell high.

2. Overrated FVGs

Overrated FVGs manifest when market prices exceed their intrinsic or fair value. This situation suggests that the asset is trading at a premium, potentially signaling a market inefficiency. 

Overrated FVGs are often associated with periods of market exuberance, where investors may exhibit excessive optimism or speculative behavior. During bull markets or asset bubbles, certain assets may become overrated.

Traders and investors consider Overrated FVGs as potential selling or shorting opportunities. They anticipate the market will eventually correct itself, returning prices to their fair value. Strategies such as short-selling or implementing hedges are common in these situations.

Suggest To Read: Order Block & Order Block Trading Strategy

What Are the Benefits of Fair Value Gaps?

Fair Value Gaps hold immense significance for price action traders for several reasons:

Strategic Entry and Exit Points: FVGs offer a unique advantage by pinpointing opportune moments to enter or exit trades. 

• Distinguishing Feature: Unlike other price gaps where no trading activity is recorded on the chart, FVGs are based on a distinct three-candlestick formation that signifies a market price action imbalance. 
• Trading Opportunities: FVGs serve as windows of opportunity for traders. These gaps indicate moments when significant imbalances between buying and selling forces lead to rapid and substantial price movements.
• Strategic Entry and Exit Points: FVGs are valuable markers on price charts. They guide traders in identifying precise entry and exit points for their trades. This strategic advantage allows traders to make well-informed decisions about when to initiate or close positions.
• Market Inefficiencies: FVGs are the result of flaws in the market. These inefficiencies are not sustainable in the long term, and the market tends to correct itself by gravitating back toward these levels. Recognizing and capitalizing on these inefficiencies is crucial for traders seeking profit opportunities.
• Price Target Zones: Traders often use FVGs to identify potential price target zones. Price tends to revisit areas where FVGs exist. Therefore, understanding FVGs helps traders set realistic profit targets for their trades.
• Risk Management: By understanding and using FVGs, traders can better manage risk. Based on these gaps, they can set stop-loss orders and profit-taking levels, helping them protect their capital and maximize returns.
• Order Flow Analysis: FVGs are often used with order flow analysis. Traders assess the prevailing order flow (buying or selling pressure) to determine the strength and potential of FVGs. 

The Use Cases of Fair Value Gaps

The practical use of Fair Value Gaps (FVGs) in trading is essential for informed decision-making and profitable outcomes. Here’s how traders practically use FVGs:

• Historical Data Analysis: Traders begin by examining historical price charts to identify instances of FVGs. They analyze past occurrences of these gaps to understand their characteristics and potential impact on price movements.
• Real-time Market Scanning: Advanced trading platforms and software tools allow traders to scan real-time market data for emerging FVGs. They set up alerts to be notified when FVGs appear, ensuring they don’t miss potential opportunities.
• Volume Analysis: Traders take FVG trading volume into account. Stronger buying or selling pressure is typically reflected in higher trade volumes, influencing trading choices.
• Depth of Market (DOM) Data: Traders utilize DOM data to assess the order book and determine whether the market has significant liquidity imbalances. This data helps in confirming the presence of FVGs.
• Position Sizing: Based on historical statistics related to FVG outcomes, traders adjust their position sizes to manage risk effectively. They may allocate smaller positions when dealing with higher-risk FVGs.

Consequent Encroachment and Liquidity Void in FVG

In Fair Value Gaps (FVG), two critical concepts often come into play: “Consequent Encroachment” and “Liquidity Void.” These terms are integral to understanding the dynamics of FVG trading and their profound impact on market behavior. 

Let’s explore the significance of these concepts in the context of FVG and how they influence trading decisions.

Consequent Encroachment in Forex

Consequent encroachment in forex trading refers to a situation where a Fair Value Gap (FVG) is partially filled, typically by around 50%. This specific point is the “mean threshold” of the FVG.

Traders need to understand this concept as it can significantly impact trading decisions. 

Traders often use historical data to assess how frequently consequent encroachment occurs and whether it tends to stop at the mean threshold. Analyzing past instances can provide insights into the reliability of this phenomenon and guide trading strategies.

Example: Let’s say a currency pair experiences a sharp price movement that creates an FVG. If the price retraces and fills only half of the gap, reaching the mean threshold, that’s considered consequent encroachment. For instance, if an FVG spans 100 pips, reaching the mean threshold would involve a 50-pip retracement.

Liquidity Void

Liquidity voids are another critical concept in forex trading. They occur when the price of a currency pair experiences a rapid and substantial movement in one direction, often characterized by large candlesticks with limited trading activity. 

Traders analyze historical price data to identify instances of liquidity voids and assess how the market typically reacts after such voids are formed. This analysis can include measuring the time it takes for the return price and the retracements’ magnitude.

Example: Suppose a currency pair experiences a sudden surge in buying pressure, causing prices to shoot up rapidly with only a few small, insignificant wicks on the candles. This signifies a liquidity void. Traders anticipate that, eventually, the price will return to close this void.

Read More: Liquidity Trading Strategy: Unveiling the Secrets

How to Spot FVGs on a Price Chart?

Identifying a Fair Value Gap (FVG) on a price chart can be challenging but is crucial for traders looking to spot potential trading opportunities. The FVG strategy involves a specific three-candle pattern, and recognizing it requires attention to detail. 

Here are the steps for finding FVGs on the chart:

1. Identifying the Significant Candlestick

Begin by examining your price chart for a notable candlestick that stands out due to its size and price movement. Ideally, this candlestick should have a significant body-to-wick ratio of around 70%.

2. Analyzing Surrounding Candlesticks

Once you’ve spotted the substantial candlestick, focus on the preceding candles and follow it. Consider whether these neighboring candlesticks overlap entirely with the significant one. 

You’re looking for minor overlaps at the upper and lower ends of the significant candlestick.

3- Defining the Fair Value Gap (FVG)

To define the Fair Value Gap, pinpoint the gap between the wicks of the neighboring candlesticks. This gap is the essence of the FVG.

4. Applying FVG Rules in Different Trends

In a Bearish Trend (Selling Opportunity): 

1. Identify a large bearish candlestick.
2. Observe a smaller candlestick preceding it (with minor overlap).
3. Locate another smaller candlestick following the large one (with minor overlap).
4. The Fair Value Gap comprises the price range between the low of the preceding small candlestick and the high of the following small candlestick.

In a Bullish Trend (Buying Opportunity):

1. Look for a large bullish candlestick.
2. Examine a smaller candlestick preceding it (with minor overlap).
3. Identify another smaller candlestick following the large one (with minor overlap).

The Fair Value Gap encompasses the price range between the high of the preceding small candlestick and the low of the following small candlestick.

5. Drawing the Fair Value Gap on Your Chart

Draw it on your price chart after successfully identifying the Fair Value Gap according to the criteria. This visual representation helps traders visualize the gap and its significance.

The EUR/GBP 15-Min chart above shows the fair value gap candlestick pattern. When you notice a substantial candlestick, a smaller one before it, and another small one after it, you have identified an FVG. 

Identifying FVGs is valuable for traders as it can help uncover market imbalances and potential trading opportunities. By following these steps and adhering to specific rules, traders can effectively incorporate FVGs into their trading strategies.

How to Trade With Fair Value Gap?

Trading using Fair Value Gaps (FVGs) involves a strategic approach to capitalize on market imbalances and potential reversals. Here are essential steps to effectively implement the Fair Value Gap Trading Strategy:

1. Set the Trend

Start by identifying the prevailing market trend. If the price consistently forms higher highs and higher lows, it indicates an uptrend, suggesting you should look for buying opportunities. 

Conversely, if lower highs and lower lows form, it signals a bearish trend, and you should focus on selling opportunities. To confirm the trend, consider using trend lines and channels and switching to higher timeframes for a broader perspective.

2. Determine Market Supply and Demand

Once you’ve established the trend direction, the next step is to pinpoint supply and demand zones or order blocks that align with that trend. The simplest way to do this is by using the first candle that formed the FVG. 

In a bullish trend, focus on demand zones where buying interest is strong, potentially driving prices higher. In a bearish trend, target supply zones where selling pressure may dominate. These zones represent areas on the chart where significant price movements are likely to occur.

3. Identify a Valid Fair Value Gap

Determine a valid Fair Value Gap on your price chart. Look for a conspicuous candlestick followed by smaller ones, ensuring that these smaller ones exhibit minor overlaps with the significant candlestick. The gap between the wicks of the neighboring candlesticks defines the Fair Value Gap. 

4. Confirm the FVG with Technical Indicators

Once you’ve spotted a potential FVG, confirm its validity with the assistance of technical indicators. Use tools like moving averages, the Relative Strength Index (RSI), or the Stochastic Oscillator to gain further insights into the strength of the potential trade setup. This confirmation step enhances your confidence in the trade.

5. Use FVG to Determine the Entry Point

Identify the formation of the Fair Value Gap itself. You can use tools like the Fair Value Gap Indicator by Lux Algo on TradingView to identify FVGs automatically. 

When a price gap closes within a supply or demand zone, consider entering a position in the direction of the initial price movement. The presence of an FVG suggests a market imbalance that is likely to be corrected, potentially leading to favorable price movements in your favor.

6. Set Stop-Loss and Target Profit

Implement robust risk management by setting appropriate stop-loss and target profit levels. If you’re entering a trade from a supply or demand zone, place your stop loss above (for short positions) or below (for long positions) that zone, or even better, above the first candle of the FVG three-candle formation. 

This method safeguards your capital in case the market moves against your position. Your target profit should be set just beyond the next demand or supply zone in the direction of your trade, representing a potential reversal point where you can secure your profits or extend them in case of a significant trend.

7. Monitor Market Developments

Actively monitor market developments after entering the trade. Keep a vigilant eye on price movements and how they correlate with the identified FVG. 

Be ready to adapt your trading strategy if market conditions evolve differently. This ongoing monitoring ensures that you remain in control of your trade.

Mastering FVG: Essential Tips for Traders and Investors

Here, we will explore essential tips that will empower you to make informed decisions and unlock the full potential of FVG in your trading and investment journey.

• Select a Suitable Timeframe: Select an appropriate timeframe for your analysis. The choice of timeframe depends on your trading style, whether you’re a day trader, swing trader, or long-term investor. Different timeframes may reveal different FVGs.
• Spotting Price Gaps: Pay close attention to price gaps on the chart. An FVG typically appears as a gap between one candlestick’s closing price and the next’s opening price. These gaps can be bullish (price rises) or bearish (price falls).
• Analyze Candlestick Patterns: Study the candlestick patterns that form near the gap. FVGs are often accompanied by specific candlestick patterns, such as doji candles or hammers. These patterns can provide additional confirmation.
• Volume Confirmation: Confirm the FVG with volume analysis. Significant price gaps should ideally be accompanied by above-average trading volume. An increase in volume suggests stronger buying or selling pressure, reinforcing the validity of the FVG.
• Assess Market Sentiment: Consider the overall market sentiment when identifying FVGs. Are there any relevant news events or economic releases that may have triggered the price gap? Understanding the context can help you gauge the significance of the gap.
• Draw Trendlines and Support/Resistance: Utilize trendlines and support/resistance levels to identify the areas where FVGs are likely to occur. FVGs often manifest near key technical levels, such as trendline intersections or strong support/resistance zones.
• Confirmation and Entry: Once you’ve identified a potential FVG, look for confirmation signals, such as a reversal pattern or a change in momentum, before entering a trade. Consider your risk management strategy and set stop-loss orders to protect your capital.

The Final Thought

Fair Value Gap Trading Strategy (FVG) isn’t just another trading tool; it’s a powerful compass that helps traders navigate the turbulent waters of financial markets. By identifying market imbalances and offering strategic entry and exit points, FVG transforms complexity into clarity and uncertainty into opportunity. 

As you embark on your trading journey, remember that mastering FVG takes practice and dedication. Still, the rewards for informed decisions and potential profits are worth the effort. 

So, set your course, keep learning, and may your trading adventures with FVG lead you to success in the ever-changing world of finance. 

Happy trading!