Price action traders often use various tools and strategies to understand market movements, and one concept they rely on is the fair value gap. But what exactly is a fair value gap? Simply put, it’s a gap in price movement that occurs when there’s an imbalance between buying and selling. This creates an area on a chart where prices haven’t fully adjusted, which can often attract the price back before it continues in its original direction.
What is fair value gap trading strategy?
The fair value gap trading strategy is a method used to take advantage of gaps in price movement on a chart. Here’s how it works in simple terms:
- Find the gap: Traders look for a specific pattern on the chart where there’s a gap between candles. This happens when a large price movement creates a space that the following candles don’t fully cover.
- Wait for the price to return: Once a gap is identified, traders wait for the price to move back towards this gap. The idea is that prices often return to fill this gap before continuing in the direction they were initially heading.
- Make a trade: After the price moves back to the gap, traders make a trade based on the direction of the original price movement. For example, if the price was moving up before creating the gap, traders might buy when the price returns to the gap, expecting it to go up again.
- Manage risks: Since the market might not always follow this pattern, traders use risk management techniques like stop-loss orders to protect themselves from potential losses.
In essence, this strategy helps traders take advantage of price gaps by betting that the price will move back towards and then continue in the direction of the original trend.
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Fair value gap example
Let’s say the Bitcoin CFD price is currently trading at $66,000, and you notice a fair value gap on the chart. Here’s a simple example of how it works:
- Identify the gap: Imagine that on a recent day, Bitcoin’s price surged quickly from $62,000 to $68,000 in a single large price movement, creating a gap. The next candle on the chart shows Bitcoin moving from $68,000 to $67,500, but it doesn’t fully cover the space between $62,000 and $68,000. This creates a visible gap on the chart.
- Wait for the price to fill the gap: According to the fair value gap strategy, you would wait to see if the price comes back to this gap. In this case, you’d be watching to see if Bitcoin’s price falls back towards the $66,000 to $62,000 range.
- Make a trade: If Bitcoin’s price does move back to around $64,000, which is within the gap area, you might consider buying, expecting that Bitcoin will then continue to rise, filling the gap and following the original upward trend.
- Manage risks: To protect yourself in case the price doesn’t follow this pattern, you would set a stop-loss order. For example, you might set a stop-loss at $63,000 to limit your potential losses if the price keeps falling.
Pros and cons of fair value gaps
| Pros | Cons |
|---|---|
| Fair value gaps provide specific levels where traders can enter trades, making it easier to plan and execute trades. | Gaps might not always be filled, leading to potential losses if the price does not behave as expected. |
| Gaps highlight areas where market imbalances occurred, which can help traders understand price movements. | Waiting for the price to return to the gap can take time, and traders need patience to see results. |
| Often, prices return to fill gaps and then continue in the direction of the trend, supporting trend-based strategies. | The strategy might not work in all market conditions, and gaps may not always predict future movements accurately. |
| Provides a clear point to set stop-loss orders and manage risk effectively. | Identifying gaps manually can be challenging and time-consuming without proper tools or indicators. |
Summary
As you've seen, the fair value gap strategy involves looking for price gaps, waiting for the price to move back into the gap, and then making a trade based on the expectation that the price will continue in the direction of the original trend. Source: investopedia.com
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FAQs
1. How is a fair value gap identified on a chart?
A fair value gap is identified in a triple-candle pattern. It occurs when a large price movement creates a gap between the high of one candle and the low of the following candle, which do not overlap completely. Traders can identify these gaps manually or use specialized indicators.
2. How can I use the fair value gap strategy in trading?
To use the fair value gap strategy, first identify the gap on the chart. Then, wait for the price to move back towards the gap. Once it reaches the gap area, you can make a trade based on the expectation that the price will continue in the direction of the original trend.
3. What are the main advantages of trading with fair value gaps?
The main advantages include clear entry points for trades, the ability to identify market imbalances, support for trend continuation strategies, and effective risk management through precise stop-loss orders.
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4. What are the potential risks of using the fair value gap strategy?
Potential risks include false signals where the price does not return to the gap or does not move as expected, and the need for patience as waiting for the price to fill the gap could take time. The strategy may also be less reliable in certain market conditions.
5. Can fair value gaps be used in any market?
Yes, fair value gaps can be applied to various markets, including stocks, Forex, indices, commodities and cryptocurrencies. However, the effectiveness of the strategy may vary depending on market conditions and the asset being traded.
6. How can I enhance my use of fair value gaps in trading?
To enhance your use of fair value gaps, consider using technical analysis tools and indicators that help identify gaps more accurately. Additionally, combining this strategy with other analysis techniques and maintaining disciplined risk management practices can improve your trading outcomes.
