Definition
A fair value gap in trading means the difference between a currency or stock’s fair value and the market value due to an imbalance. Imbalance in trading is directly proportional to the Fair value gaps. FVG also represents it.
The fair value gap is the most critical and advanced concept of technical analysis. Because the whole market of the world is based on the concept of balance and imbalance. And the FVG is highly relevant to this concept.
In this article, I will explain the fair value gap in detail and a trading strategy.
How to find the fair value gap on the chart?
To identify the fair value gap on the candlestick chart, follow the following criteria:
- First, find a big-body candlestick with more than 60% body-to-wick ratio in the last 20 to 40 candlesticks range.
- Then check the neighboring candlesticks. The previous and forward candlesticks should not overlap the body of the big candlestick.
This phenomenon indicates a gap or imbalance on the price chart.
Look at the image below for a better understanding of this pattern.
Types of the fair value gap
Based on the opening and closing price of the big candlestick, the fair value gap is categorized into two types.
- Overrated fair value gap
- Undervalued fair value gap
Overrated fair value gap
The market price will be higher than the fair value of this type. That’s why it is called an overrated FVG. On the candlestick chart, we can identify it with a big bullish candlestick with no overlapping of neighboring candlesticks.
Undervalued fair value gap
This type of market price will be lower than the fair value, called the undervalued fair value gap. In technical analysis, you will see a big bearish candlestick with no overlapping neighboring candlesticks.
How to draw a fair value gap zone?
The criteria to draw the FVG zone differ for undervalued and overrated FVG.
- Use the low of the previous candlestick and the high of the forward candlestick to draw the zone in case of the undervalued fair value gap.
- Use the low of the forward candlestick and the high of the previous candlestick to draw the zone in case of overrated FVG.
Remember that I’m referring to the previous and forward candlesticks concerning the big candlestick.
Significance of fair value gap in trading
One of the essential concepts of nature is that everything in the universe wants balance. The same concept applies to the real market. The market price also wants to stay balanced. Whenever an imbalance occurs, then the market will try to balance itself.
I’m explaining it with an example, and you should understand it correctly.
For example, if an overrated fair value gap forms on the candlestick chart, it means the price is higher than the fair value and imbalanced.
Then how can the market achieve a balanced state?
Price will retrace downward to its fair or actual value to achieve the balance.
This is the principle of nature, and the market will always follow it.
So if you find an imbalanced state on the candlestick chart, you can trade in the direction of FVG to get very high probability trade setups.
Importance of fair value gap
One of the best things I love about the fair value gap concept is that it gives me a particular direction to trade. After determining the trend direction of market makers using the FVG concept, I can trade in that direction without any psychological issues.
It will also help you in finding very high-risk reward ratio trade setups.
For example, if you find an undervalued fair value gap, you can trade in the bearish direction. In this way, the probability of winning of sell trade setups will be higher than the buy trade setups. That’s why I will only open-sell trades in case of undervalued FVG patterns.
How to trade the fair value gap?
A trading strategy requires entry rules, stop loss, and take profit levels. However, a simple, fair value gap does not provide the rules for a complete trading strategy. That’s why we will use other technical tools like chart patterns and candlestick patterns to trade.
Open a buy trade
Find an undervalued fair value gap and then look for bullish chart patterns. Then open a buy trade and place a stop loss accordingly to the chart pattern.
Here the target is the balanced state. That’s why the place takes profit level at the lower limit of the fair value gap zone.
Open a sell trade
Identify an overrated fair value gap and then look for bearish chart patterns. Then open a sell trade and place profit at the high fair value gap zone.
In this strategy, stop loss depends on the type of chart pattern. So it will be different for different chart patterns.
Conclusion
I highly recommend that all traders use the concept of fair value gap in trading because this pattern can help you get high-risk rewards, high-probability trades, and fewer psychological issues.
The simple FVG rule is that “Determine the direction and the trade in that direction until the market achieves balance.”
