Introduction
While the concept of Fair Value Gap (or FVG) is usually associated with long-term investors, it also plays a vital role in short-term trading too. So much so that there are many traders specialized in trading FVGs and little else.
In today’s article, we’ll learn what a Fair Value Gap is, how to identify one, and how to trade it.
Let’s dive in!
What is a Fair Value Gap?
Just as the name suggests, Fair Value Gap trading involves identifying price gaps that occur when the market reacts to temporary changes in a stock’s fundamentals, such as news releases or large buy/sell orders.
These gaps often represent areas where price has moved too quickly, and it may need to retrace to “fill” these gaps, returning to what was previously perceived as the “right” fair value.
In simple terms, an FVG exists when there is a divergence between the current price and the price and the perceived intrinsic value. This gap creates an opportunity for traders to enter or exit positions based on the expectation that the price will move back toward its fair value. And that’s pretty much what FVG trading is all about.
On January 19, 2021, Netflix reported its fourth-quarter earnings. The results showed a massive increase in subscriber growth causing price to gap up massively by the next day’s open.
On January 20, 2021, Netflix’s stock opened at around $565 after closing at around $500 the previous day. The extreme gap presented an opportunity for traders watching for a potential retracement or those looking to short the stock at the top of the gap.
During the following few days, a combination of underwhelming actual profit and investors’ concerns over future growth rates have pushed price back down till the FVG was fully filled.
How do traders identify Fair Value Gaps?
To spot FVGs, traders need to make use of their technical analysis skills and a pinch of understanding of trading psychology.
If you think you have both, here are a few tips you might find useful:
Look for Gaps in Price Action
The simplest method of identifying an FVG is by looking for one on a trading chart. Significant price movements (especially those following news or earnings reports), can create gaps. On a chart, they often appear as a noticeable jump in price between a candle’s close and the next candle’s open price without any trading occurring in between.
Analyze Market Sentiment
As we said earlier, a fair value gap is created when price diverges from the perceived intrinsic value. Since both “current price” and “perceived intrinsic value” are directly linked to market sentiment, this is usually well worth analyzing too.
Tools such as Sentiment Analysis Indicators or the Social Sentiment Index can help you identify prevailing moods in the market.
Check Volume
While high trading volumes during price gaps can indicate strong interest and somewhat confirm the likelihood of the gap being filled, low volume, on the other hand, may suggest that the price movement may not be strong enough to fill the gap completely (or even partially).
Check for Previous Support and Resistance Levels
Historical support and resistance levels can provide insight into ideal levels where price might return to fill the gap.
How to Trade Fair Value Gaps
Now that you know how to identify a Fair Value Gap, the next step is learning how to trade it.
This is what most traders usually do after spotting an FVG and what you can do too to start right now:
Set entry and exit levels
Once you identify a gap, determine the entry point at or near the gap’s optimal price level (the market’s perception of the stock’s intrinsic value). Set your stop-loss orders below the gap for bullish trades and above it for bearish trades.
Follow the market trend
Align your trades with the broader market trend. If the overall market is bullish, go for long positions when entering through FVGs, and vice versa for bearish trends. Following the overall market trend increases the chances of successful trades.
Consider the Fair Value Gap across different time frames
Analyze FVGs across various time frames keeping in mind that gaps in shorter time frames are usually more numerous and can provide more and different opportunities. Higher time frames, on the other hand, often have more significant implications and dramatic retracements.
Monitor Market News:
Be aware and keep an eye on upcoming news events or economic data that might impact the asset’s price. These events can sometimes cause sudden volatility and potentially affect your FVG trading strategy.
Backtest Strategies:
As for all other trading strategies, do use your diligence, and use historical data to backtest your FVG trading strategy before implementing it. Check results to evaluate performance and make the necessary adjustments.
Following news of an antitrust investigation launched by the Chinese Government on Alibaba (BABA), the stock price dropped from around $255 at the 23rd December 2020 market close to just above $211 at the opening of the following day thus creating an FVG of over 17%.
Once again, positive sentiment toward the stock and strong sales figures pushed price back up to fair value and made FVG traders exceedingly good profit in just a few days.
Conclusion
Fair Value Gap trading offers a unique perspective on price movements and market inefficiencies, and it allows FVG traders to step into positions that match their expected price corrections.
Once you fully understand how to identify, analyze, and trade FVGs, you’ll have added another great tool to your trading arsenal. It’s only forward and upward from there!
Hope this helps!
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