The Powerful Fair Value Gap Trading Strategy

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The fair value gap (FVG) trading strategy has become an increasingly popular approach among price action traders in recent years. This strategy aims to identify and capitalize on short-term inefficiencies or “gaps” in the market where buying and selling forces are imbalanced.

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What is a Fair Value Gap?

A fair value gap refers to a gap between the current market price and the estimated “fair” value of an asset based on its fundamentals. It typically occurs when there is a large, rapid price movement due to a market imbalance between buyers and sellers[1].

Specifically, a FVG pattern consists of three candles on a price chart:

Candle 1: A long bullish or bearish candle with a large range from high to low
Candle 2: An even larger candle continuing the trend in the same direction
Candle 3: A candle that does not share any common prices with Candle 1, leaving a “gap”

Fair value gap example

A FVG highlighted on a chart [2]

This gap between Candles 1 and 3 represents an imbalance between buying and selling pressure, creating a liquidity void. The assumption is that price will eventually return to “fill” this gap near the fair market value before continuing the overall trend.

FVGs can occur on any timeframe, from 1-minute charts up to daily or even weekly charts. They provide traders with high-probability short-term turning points to anticipate reversals or retracements.

Why Trade Using Fair Value Gaps?

There are several key benefits to using a FVG trading strategy:

Identifies Imbalances: FVGs clearly highlight on a chart when buying/selling pressure causes short-term inefficiencies. This allows traders to easily spot market imbalances.
High Probability: Statistics show price reversals tend to occur near FVGs around 70% of the time as the market moves to fill the liquidity void[1].
Precise Entries: FVGs indicate exact price levels for traders to target entries, creating very precise points of reference.
Works on All Timeframes: The same principles apply to FVGs on 1-minute charts up to weekly charts, making this a versatile strategy.
Simple Concept: Focusing just on the specific FVG pattern keeps analysis objective and simple compared to more complex indicators.

Overall, the FVG strategy provides a probabilistic approach that simplifies analysis. By using FVGs to anticipate short-term turning points, traders can precision-target entries and efficiently capitalize on price swings.

How to Trade Using Fair Value Gaps

Trading with fair value gaps follows three key steps:

1. Identify the FVG Pattern

The first step is visually identifying the characteristic FVG pattern on the chart of your chosen market and timeframe.

You’ll want to see a long bullish or bearish candle (Candle 1), followed by an even larger continuation candle (Candle 2), completed by a third candle (Candle 3) which leaves a gap from the first candle’s range.

If using charting software, you can apply a FVG indicator which will automatically highlight on your chart where these patterns occur, making them easier to spot.

2. Target Entries Near the Gap

Once you detect a FVG pattern, the gap level itself represents an ideal area to target entries for a high-probability reversal trade.

You’ll be looking to enter a short trade targeting a move back up to fill the gap after a down-move. Conversely, enter long trades aiming to fill FVG gaps created after upside moves.

Since you’ll be trading pullbacks/retraces, consider using other analysis like support/resistance or trendlines to fine-tune entries and stop losses.

3. Close at Opposing Levels

You can close FVG reversal trades as soon as price reaches the “fair value” gap level, taking quick profits.

However, more patient traders will aim for a risk/reward ratio of at least 1:2 by targeting opposing levels to close. For example, they may close short trades once price reaches former support zones or long trades at former resistance.

This allows capturing larger gains if the market continues reversing beyond just filling the liquidity void. Just be sure to trail stops to lock in profits.

Real Chart Examples

To see how it works in real market conditions, let’s analyze example FVG setups and trades:

Gold Futures 4hr Chart

Gold futures FVG example

Entering short on gold futures using the FVG strategy [2]

On this gold futures 4hr chart, a large bearish move created a FVG buy imbalance, highlighted by the shaded blue zone.

We can target short trades aiming for price to return to “fair value” near $1815. The initial 3:1 risk/reward is very favorable for this type of reversal setup.

EUR/USD Daily Chart

EUR/USD FVG

Here we see a bearish FVG pattern on the daily EUR/USD forex pair after a strong down move. This presents an area around 1.064 to target long bounce trades, with a stop under the low and target up near horizontal resistance.

These examples demonstrate how traders across different markets can apply the exact same FVG rules and concepts.

Optimizing the FVG Strategy

While the underlying concept is simple, there are several ways to further optimize trading with FVGs:

Time FVGs with momentum – Enter trades shortly after price reverses near the gap rather than anticipating. This timing aligns entries with momentum.
Focus on wider gaps – The bigger the buying/selling imbalance, the higher probability the gap gets filled after a reversal.
Use multiple timeframes – Zoom into shorter timeframes to refine entry and stop loss levels near gaps identified on higher timeframes.
Combine with other indicators – Corroborate trades using complementary indicators like RSI, MACD histogram, Stochastics, etc.
Have a trading plan – Quantitatively define optimal risk/reward, win rate targets and use sound risk management per your trading plan rules.

A systematic, plan-based approach takes the FVG strategy to the next level.

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Fair Value Gap Trading Strategy Risks and Challenges

Of course, like any trading method, the FVG strategy presents risks to be aware of.

FVG gaps may not get filled – There’s still a chance price continues trending right through a gap without filling it. Use stop losses on every trade.
Requires patience – Traders must wait for perfect FVG setups and resist overtrading.
Not suited for all markets – Lower liquidity instruments with wider spreads pose challenges.

Additionally, markets don’t always move in clearly defined patterns. Traders may struggle to consistently and accurately identify precise FVG levels, reducing the strategy’s effectiveness.

Nonetheless, the high-probability nature of FVGs makes persisting through these challenges worthwhile for most short-term traders.

Fair Value Gap Trading Strategy Conclusion

In summary, the fair value gap trading strategy offers a probabilistic tactic to spot and take advantage of short-term mispricings and liquidity voids in the market.

FVGs provide very clearly defined trade setups that occur across all markets and timeframes. By combining the simple FVG rules with savvy analysis and risk management, traders can gain an edge with this powerful approach.

While trading carries inherent risks, the odds typically favor those patient and skilled enough to effectively leverage gaps in market fairness.