A fair value gap is a term often used by price movement traders. It occurs when there is an imbalance between buyers and sellers, creating an area on the chart where the price has not fully corrected. This gap can attract the price back before it continues in its original direction.
What is a fair value gap trading strategy?
A fair value gap trading strategy is a technique that allows traders to use price gaps to enter trades. Here's how it works:
- Find the gap: Traders look for patterns on the chart where a gap appears between candles. This happens when a sharp price movement creates a gap that the following candles don't fill completely.
- Wait for price to return: Once a gap is detected, traders wait for price to return to that gap. Often prices will return to fill the gap before continuing in the original direction.
- Execute the trade: When price returns to the gap, traders open a position depending on the direction of the original price movement. For example, if the price was rising before the gap was formed, a trader may buy, expecting the price to go up again.
- Risk Management: Since the market does not always follow predictable patterns, traders use risk management techniques such as stop-loss orders to protect themselves from potential losses.
Thus, this strategy allows traders to utilize price gaps, assuming that price will return to the gap and continue in the original trend.
Example of a fair value gap
Let's say the Bitcoin CFD price is trading at $66,000 and you notice a gap on the chart. Here's a simple example of how this might work:
- Identify the Gap: Imagine that the price of Bitcoin recently spiked from $62,000 to $68,000, creating a gap in the chart. The next candle shows the price dropping from $68,000 to $67,500, but not completely filling the gap between $62,000 and $68,000.
- Wait for price to return to the gap: According to the fair value gap strategy, you will wait for price to return to the gap level. In this case, you will be watching to see if the price of Bitcoin returns to the $66,000-$62,000 range.
- Open a trade: If the Bitcoin price returns to the $64,000 level inside the gap, you may consider buying, expecting the price to continue rising and close the gap, following the original uptrend.
- Risk Management: To protect yourself in case the price does not follow the expected scenario, you can set a stop-loss order, for example at the $63,000 level, to limit potential losses if the price continues to fall.
Advantages and disadvantages of trading on fair value gaps
Advantages:
- Clear levels to enter trades, which simplifies trade planning and execution.
- Highlighting areas of market imbalance, which helps to better understand price movement.
- Support for trend-following strategies, as prices often come back to fill the gap and then continue on trend.
- Clear points for setting stop-loss orders, which helps to manage risk effectively.
Disadvantages:
- Gaps may not always close, leading to potential losses if price does not behave as expected.
- Waiting for price to return to the gap can take time, requiring patience from the trader.
- The strategy may not work under all market conditions, and gaps do not always accurately predict future price movement.
- Manually identifying gaps can be time consuming and difficult without the use of special tools or indicators.
Bottom line
The fair value gap trading strategy involves finding price gaps, waiting for the price to return to the gap, and opening a trade with the assumption that the price will continue in its original trend.
Frequently Asked Questions
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How do I identify a fair value gap on a chart? A fair value gap can be identified in a three candlestick pattern when a gap is formed between the top point of one candle and the bottom point of the next candle that does not overlap. Traders can identify such gaps manually or use special indicators.
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How to use the strategy of trading on fair value gaps? First, you need to identify the gap on the chart. Then wait for the price to return to the gap area. Once this happens, you can open a trade based on the assumption that the price will continue in the original trend direction.
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What are the main advantages of trading on fair value gaps? Benefits include clear entry points, the ability to identify market imbalances, support for trend continuation strategies and effective risk management through stop losses.
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What are the risks of using a fair value gap strategy? Risks include false signals when price does not return to the gap or does not move in the expected direction. The strategy also requires patience, as it can take time for price to return to the gap, and it may be less reliable in certain market conditions.
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Can fair value gaps be used in any markets? Yes, fair value gaps can be used in a variety of markets including equities, forex, indices, commodities and cryptocurrencies. However, the effectiveness of the strategy can vary depending on market conditions and the asset being traded.
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How to improve the use of fair value gap strategy? To improve the use of the strategy, it is recommended to use technical indicators to help identify gaps more accurately, as well as to combine it with other analytical methods and strictly follow risk management rules