What is the Fair Value Gap (FVG)?

How to Identify a Fair Value Gap on a Price Chart

How to Trade Using FVGs – The Fair Value Gap Trading

Strategy
Fair Value Gap Trading
In the financial markets, where every decision is a step towards profit or loss, having an
edge over the market is invaluable. Now, imagine having the power to naturally spot
trading opportunities others might miss, all while simplifying your strategy.

That’s where the Fair Value Gap trading strategy comes in. This strategy, used mainly by
price action traders, is extremely simple yet incredibly powerful.

What is the Fair Value Gap (FVG)?

The concept of fair value gap goes by different terminologies among price action
traders. Some call it imbalance, inefficiency, or liquidity void. But what exactly are these
imbalances? They occur when buying and selling forces exert significant pressure,
leading to substantial and rapid price movements. These movements, whether bullish or
bearish, create gaps in the market, which are essentially the bread and butter of the FVG
strategy.

The FVGs concept is rooted in the belief that the market naturally tends to correct itself.
These price disparities or inefficiencies are not sustainable in the long term, and the
market tends to gravitate back towards them before continuing in the same direction as
the initial impulsive move.

FVGs provide a unique advantage by revealing entry and exit points in the market. Like
many other types of price gaps, these FVG imbalances act as markers on the chart,
guiding traders on when to get in and out of a position. The FVG is based on a three-
candlestick formation that creates an imbalance in the market’s price action. When this
substantial move suddenly occurs, whether upward or downward, it leaves a gap
between the first candle’s wick and the final candle’s wick; this is the FVG.
The gap in the above chart signifies an opportunity – a potential return to equilibrium. In
this example, we can see the three-candle bearish formation where the lowest price of
the first and the highest price of the third candle leave a hypothetical gap. Usually,
following this formation, the markets tend to create a U shape and turn back to fill this
gap.

It’s at this juncture where liquidity voids occur that traders can make informed decisions,
leveraging the power of FVGs to capitalize on market corrections and profit from the
realignment.

How to Identify a Fair Value Gap on a Price

Chart
Like most chart patterns, the most tricky part of the fair value gap strategy is identifying
this unique formation on a price chart. In the case of FVGs, a three-candle pattern must
appear with specific rules. Then, when this happens, the space or gap between the wicks
of the first and third candles is the fair value gap.

Here is how to identify an FVG on the chart:

1. Spotting the Big Candlestick: The first step in identifying a Fair Value Gap is to look
for a substantial candlestick on your price chart. This candlestick should have a
significant body-to-wick ratio, ideally around 70%.
2. Analyzing Neighboring Candlesticks: Once you’ve identified the large candlestick,
analyze the ones immediately preceding and following it. These neighboring
candlesticks should not overlap the significant one entirely. Instead, minor overlaps
may occur on the upper and lower sides of the substantial candlestick. Then, it is the
gap between the wicks of neighboring candlesticks that create the fair value gap.
3. Defining the Fair Value Gap: Finally, you must define the fair value gap and draw it
on your price chart. In a bearish trend, the Fair Value Gap is the price area between
the previous candlestick’s low and the following candlestick’s high. This is where the
imbalance in the market becomes apparent, signifying a potential trading
opportunity. The same applies to a bullish trend but with the opposite conditions.

In the EUR/GBP 15-Min chart below, you can see what the fair value gap candlestick
pattern looks like on a price chart. Once you notice a big candlestick with a small candle
prior to it and another small candle that appears after the big candlestick, you can
search for the fair value gap entry level.
Additionally, Fair Value Gaps come in two distinct flavors, each carrying its own set of
implications for traders:

1. Undervalued Fair Value Gap (Bearish Fair Value Gap)

This type of FVG suggests that the price of a currency pair or any other financial asset is
currently below its fair value. In simple terms, traders can anticipate that the market will
retrace to correct this inefficiency. When you spot a significant bearish candlestick on
your chart, it’s likely signaling the presence of an undervalued FVG.

2. Overrated Fair Value Gap (Bullish Fair Value Gap)

Conversely, an Overrated FVG indicates that the price of a currency oaur or financial
asset is currently trading above its fair value. Here, the market is overheated, and a
correction is on the horizon. Traders can expect the price to retrace as the market
balances itself before going up.
How to Trade Using FVGs – The Fair Value
Gap Trading Strategy
In this section, we will show you how to use this FVG trading strategy. So, here’s how to
trade it:

1. Determine the Trend

Trends play a pivotal role in this strategy. If the price is consistently forming higher highs
and higher lows, you’re in an uptrend, and you should be looking to buy entries.
Conversely, if the price is forming lower highs and lower lows, it indicates a bearish trend,
and you should focus on selling entries.

Establishing the trend direction provides you with a fundamental framework for your
trading decisions. If needed, switch to higher time frames, such as 1H, daily, and weekly.
Also, to identify the market’s trend, you can trend lines and trend channels.
2. Identify Supply and Demand Zones
Once you’ve determined the trend, the next step is identifying supply and demand zones
or order blocks that align with that trend. The simplest way to draw supply or demand
zones is using the first candle that formed the FVG.

In the context of a bullish trend, pay particular attention to demand zones. These zones
are areas where buying interest is strong and can potentially drive prices higher.
Conversely, in a bearish trend, you’ll want to focus on supply zones, where selling
pressure may dominate. The goal here is to pinpoint areas on the chart where
significant price movements are likely to occur.

3. Use FVG to Determine the Entry Point

Next, you should identify the formation of the fair value gap. To do this, you can make
use of the Fair Value Gap Indicator by Lux Algo on TradingView, which is a powerful tool
to identify FVGs automatically. In the example below, you can see supply zones closest
to an FVG during a bearish trend. When the price closes the gap, you should consider
entering a short-sell position.

Remember, the presence of an FVG suggests a market imbalance that is likely to be

corrected, potentially resulting in favorable price movements in your favor. Following the
correction, the price is likely to move in the direction of the big candlestick or the initial
price movement.

4. Set Stop Loss and Target Profit

As with any trading strategy, risk management is vital. When executing trades based on
the FVG strategy, set appropriate stop loss and target profit levels. If you’re entering a
trade from a supply zone, you should place your stop loss above that zone or, even
better, above the first candle of the FVG three-candle formation. This helps protect your
capital in case the market moves against your position.

Your take-profit target should be set just above the next demand zone in the direction of
your trade. This zone represents a likely point where the market could reverse, allowing
you to secure your profits. However, you can use this level to extend your earnings in
case you notice a significant trend that is about to break the support level.

As you can see, the FVG trading strategy enables you to use a favorable risk-reward
ratio. The main reason for that is the use of support and resistance levels as a protection
tool.