Fair Value Gap: An Essential Tool for Technical Traders

Fair value gaps are price gaps that occur when there is a significant difference between the closing price of one trading and the opening price of the next, with minimal or no trading in between. 

If you’ve ever wondered about those sudden gaps in price on a chart and what they mean, you’re not alone. This article will show you how to spot fair value gaps, what they signify, and how to leverage them to enhance your trading decisions!

Key Takeaways

• Fair Value Gaps occur when there's a significant price difference between the close of one period and the opening of the next, signaling market inefficiencies.

• Bullish gaps indicate potential upward momentum, while bearish gaps suggest potential downward pressure.

• Use fair value gaps to pinpoint entry and exit points, manage risk, and confirm trend strength, enhancing trading decisions.

What Is a Fair Value Gap (FVG)? 

A fair value gap is a price gap that occurs when there's a noticeable difference between the closing price of one trading period and the opening price of the next. 

Essentially, they show moments when the market hasn't had enough time to digest information, leading to abrupt price changes.

Structure of a Fair Value Gap on a Chart

Here’s how you can spot a Fair Value gap on a chart:

Let's say that the gap occurs due to a significant upward price movement. 

• Initial Price Movement: First, you'll see a sharp rise in the closing price of the initial trading period.

• Gap: If the opening price of the next period is higher than the closing price of the previous period, the chart shows a blank space between the two prices.

• Next Trading Period (Continuation or Correction): 

  • Continuation: After the gap, the price may continue in the direction of the gap, indicating strong momentum.

  • Correction: Alternatively, the price may retrace to fill the gap, moving back towards the closing price of the previous period.

What Causes a Fair Value Gap?

Several factors can cause a fair value gap, including:

1. Economic News and Announcements

Major economic events, such as interest rate decisions, employment reports, and GDP releases, can cause significant market movements. 

When these announcements occur outside of regular trading hours, they can lead to a fair value gap as the market reacts to the new information once trading resumes.

2. Earnings Reports

Corporate earnings reports can also trigger fair value gaps. 

Positive or negative earnings surprises often lead to sharp price movements when the market opens, creating a gap between the previous closing price and the new opening price.

3. Market Sentiment

Sudden shifts in market sentiment, driven by geopolitical events, natural disasters, or changes in investor confidence, can cause rapid price movements that result in fair value gaps. 

These events can lead to panic buying or selling, creating gaps as the market adjusts to the new sentiment.

4. Supply and Demand Imbalances

Significant imbalances between supply and demand can cause fair value gaps. 

For example, a large institutional order placed outside of regular trading hours can create a gap as the market opens and prices adjust to reflect the new supply or demand levels.

Types of Fair Value Gaps

Fair value gaps can be categorized based on their direction and market context.

Bearish Fair Value Gaps 

A bearish Fair Value Gap occurs when there is a gap between the lowest point of the wick on the first candlestick and the highest point of the wick on the third candlestick. 

This gap typically forms within the body of the middle candlestick. 

What is crucial is that a gap has formed within the middle candlestick due to the lack of connection between the wicks of the first and third candlesticks, indicating potential downward pressure.

Bearish fair value gaps are caused by factors such as negative economic news, disappointing earnings reports, or sudden shifts in market sentiment toward pessimism. 

Bullish Fair Value Gaps

A bullish Fair Value Gap forms when there is a gap between the highest point of the wick on the first candlestick and the lowest point of the wick on the third candlestick. 

Similar to the bearish FVG, the exact direction of each candlestick is not the main focus. What matters most is the presence of a gap within the middle candlestick where the wicks of the first and third candlesticks do not meet. 

This gap signifies potential upward momentum and buying opportunities.

Bullish fair value gaps are typically triggered by positive economic news, better-than-expected earnings reports, or a sudden shift in investor sentiment towards optimism. 

Using Fair Value Gaps in Trading

Fair value gaps provide actionable insights for traders:

• Entry and Exit Points: Traders use fair value gaps to identify potential entry points when the gap is expected to be filled. Similarly, exit points can be set once the gap is closed.

• Risk Management: Proper position sizing and stop-loss orders are crucial when trading fair value gaps to mitigate potential risks.

• Practical Examples: For instance, if a stock gaps up significantly on positive news, a trader might wait for the price to retrace to fill the gap before entering a long position, anticipating a continuation of the uptrend.

The Role of Fair Value Gaps in Technical Analysis

Fair value gaps play a crucial role in technical analysis by highlighting market inefficiencies and providing traders with actionable insights. 

Identifying fair value gaps helps traders anticipate price movements. 

For example, a bullish gap up might retrace to fill the gap before continuing upward, while a bearish gap down might briefly recover to fill the gap before resuming its decline. 

These gaps indicate potential entry and exit points for traders.

Fair value gaps also confirm trend strength. In an uptrend, bullish gaps suggest continued upward momentum, while in a downtrend, bearish gaps indicate sustained downward pressure.

Fair Value Gaps vs. Other Price Gaps

Understanding the differences between fair value gaps and other types of price gaps is crucial. 

Fair Value Gaps vs. Common Gaps 

Fair Value Gaps typically indicate potential areas where the market will retrace to fill the gap, reflecting underlying market inefficiencies. 

Whereas Common Gaps often occur in non-trending markets and are usually filled quickly without significant trading opportunities.

Fair Value Gaps vs. Breakaway Gaps 

Fair Value Gaps occur during regular trading and suggest a potential retracement to fill the gap. On the other hand, Breakaway Gaps happen at the beginning of a new trend, often due to a breakout from a consolidation pattern, and are less likely to be filled immediately.

Fair Value Gaps vs. Exhaustion Gaps

Fair Value Gaps indicate a temporary market inefficiency that will likely be corrected.

However, Exhaustion Gaps occur near the end of a significant price move, signaling a potential reversal or the end of the current trend.

Advantages and Limitations of Using Fair Value Gaps

Fair Value gaps have several advantages as well as limitations:

Advantages

• Improved Market Timing: Fair value gaps help traders identify optimal entry and exit points.

• Enhanced Decision-Making: Provides clear signals based on market inefficiencies.

• Potential for Higher Profits: Effective use of fair value gaps can lead to profitable trading opportunities.

Limitations

• Potential for False Signals: Not all gaps will be filled, leading to possible false signals.

• Market Conditions: The reliability of fair value gaps can vary depending on market conditions.

• Risk Management: Requires careful risk management to avoid significant losses.

Conclusion 

Fair value gaps are price gaps that highlight market inefficiencies and potential trading opportunities. 

By identifying these gaps, traders can anticipate price movements and confirm trends, making more informed trading decisions. Join XS today and start your trading journey!

FAQs

What Does FVG Mean in Trading?

FVG stands for Fair Value Gap, indicating a price gap on a chart where there is a significant difference between the closing price of one period and the opening price of the next, with minimal trading in between.

What is the Difference Between a Bullish Fair Value Gap and a Bearish Fair Value Gap?

• Bullish Fair Value Gap: A gap between the highest point of the first candlestick's wick and the lowest point of the third candlestick's wick, indicating potential upward momentum.

• Bearish Fair Value Gap: A gap between the lowest point of the first candlestick's wick and the highest point of the third candlestick's wick, indicating potential downward pressure.

What is the Difference between Order Block and Fair Value Gap?

• Order Block: A price range where large institutional orders have been placed, acting as support or resistance zones.

• Fair Value Gap: A gap between the closing price of one period and the opening price of the next, highlighting market inefficiencies.

What is an example of a Value Gap?

A stock closes at $50 and opens at $55 the next day without trading in between, creating a $5 bullish fair value gap, indicating strong buying interest. Conversely, a close at $50 and an open at $45 would create a $5 bearish fair value gap, indicating strong selling pressure.