In price action trading, practitioners use various tools and methods to decipher market movements. One key concept employed is the "fair value gap." But what exactly does this term mean? Simply stated, a fair value gap is a gap in price movement, arising when there is an imbalance between buyers and sellers. This results in an unadjusted area on the price chart, which often attracts the price back before it continues along its prior trajectory.
What is the Fair Value Gap trading strategy?
The fair value gap trading strategy leverages price gaps visible on charts to identify potential trading opportunities. Here’s a breakdown of how it works:
Identify the Gap : Traders locate patterns on charts where gaps between candles occur. Such gaps emerge following significant price movements, leaving subsequent candles unable to close the created space fully.
Wait for Price Reversion : Once the gap is detected, traders observe whether the price returns toward the gap. The underlying assumption is that prices frequently retrace to fill these gaps before continuing along their original course.
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Execute the Trade : After the price reverts to the gap, traders initiate a position aligned with the original price direction. For instance, if the price was previously rising, traders might buy once the price returns to the gap, anticipating further upward movement.
Risk Management : Given that market behavior can be unpredictable, traders employ risk management techniques such as stop-loss orders to minimize potential losses.
In essence, this strategy allows traders to capitalize on price gaps, assuming the price will revert to the gap before resuming its initial trend.
Fair Value Gap example
Consider a scenario where Bitcoin CFD is trading at $66,000, and you spot a fair value gap on the chart:
- Identify the Gap : Suppose Bitcoin’s price rapidly surged from $62,000 to $68,000 in one movement, leaving a gap. The subsequent candle moves from $68,000 to $67,500 but does not completely cover the area between $62,000 and $68,000, forming a visible gap on the chart.
- Await Price Return : According to the fair value gap strategy, you would monitor the market for Bitcoin’s price to revert toward the gap, specifically to the $66,000-$62,000 range.
- Make the Trade : If Bitcoin’s price retraces to approximately $64,000, which lies within the gap area, you might consider entering a buy position, expecting the price to continue rising and ultimately fill the gap.
- Manage Risk : To safeguard against unfavorable price movements, you could set a stop-loss order, for example, at $63,000, to limit your losses should the price decline further.
Pros and cons of Fair Value Gaps
| Pros | Cons |
|---|---|
| Fair value gaps highlight precise entry points, simplifying trade planning and execution. | Gaps do not always get filled, which may result in potential losses. |
| They provide insights into areas of market imbalance, helping traders interpret price action. | Waiting for prices to revert to the gap can be time-consuming, requiring patience. |
| Price often revisits gaps and then follows the initial trend, supporting trend-following strategies. | The strategy may not perform well in all market conditions, and gaps may not always signal accurate future price movements. |
| These gaps allow traders to set well-defined stop-loss levels, enhancing risk management. | Manually identifying gaps without the use of indicators can be difficult and time-intensive. |
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Summary
The fair value gap strategy involves identifying price gaps, waiting for the price to return to the gap, and executing trades based on the expectation that the price will resume its original trend. This approach, while useful, requires a disciplined risk management plan and may not suit all market conditions.
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FAQs
1. How is a fair value gap identified on a chart?
A fair value gap is typically spotted in a triple-candle formation. It occurs when a substantial price move creates a space between the high of one candle and the low of the next, without full overlap. Gaps can be identified manually or with the assistance of technical indicators.
2. How can I apply the fair value gap strategy in trading?
To use this strategy, first locate a gap on the chart. Then, wait for the price to revert to the gap before making a trade, anticipating that the price will continue its previous trend.
3. What are the key advantages of using fair value gaps in trading?
The main benefits include clear trade entry points, the ability to recognize market imbalances, support for trend continuation strategies, and improved risk management through the use of precise stop-loss orders.
4. What are the potential risks of trading with fair value gaps?
Risks include false signals, where prices do not return to the gap or fail to move as anticipated. Additionally, waiting for gaps to be filled can take time, and the strategy may be less effective in certain market environments.
5. Can fair value gaps be used across different markets?
Yes, fair value gaps can be applied in various markets, including equities, Forex, indices, commodities, and cryptocurrencies. However, effectiveness may vary depending on market conditions and asset types.
6. How can I improve my use of fair value gaps?
To enhance your fair value gap trading, consider using technical tools and indicators to identify gaps better. Combining this method with other analytical strategies and maintaining disciplined risk management can further optimize your trading performance.
