Fair Value Gap: What Is It, and How to Use It in Trading?

Understanding price action and technical analysis can make the difference between consistent success and costly mistakes in trading. One powerful concept that many traders use is the fair value gap (FVG), a way to spot price imbalances that can reveal key profit opportunities.

This article will explore the fundamentals of FVGs, provide actionable trading strategies, and show how traders can refine their market approach using this concept.

What is a Fair Value Gap?

A fair value gap is a price imbalance in a financial market that occurs during volatile movements. It occurs when the market leaves behind untraded price levels due to strong buying or selling pressure. As a result, price action “skips” certain levels, creating gaps that traders can use to predict future retracements or reversals.

When a fair value gap forms, it reflects inefficiencies in the market caused by an imbalance between buyers and sellers. Over time, the market often seeks to “fill” these gaps, retracing to levels within the gap before resuming its broader trend.

For example, consider a candlestick chart. If a candlestick’s low does not overlap with the previous candlestick’s high, this creates a gap that may be filled by future price action. These gaps often serve as entry or exit signals for traders.

Types of FVG

Fair value gaps can be categorised based on market direction:

Bullish Fair Value Gap

A bullish fair value gap occurs when upward price momentum skips certain levels, leaving a gap that the price may later retrace before continuing its upward trend. For instance, during a strong rally, the price might surge, leaving a space between the previous candle’s high and the next candle’s low.

Inverse (Bearish) Fair Value Gap

An inverse fair value gap, or bearish FVG, forms during strong downward movements. In this scenario, the price skips levels on its way down, creating gaps that the market may later fill as part of a corrective move before resuming its downward trend.

Both types of FVGs are rooted in the market’s natural tendency to seek balance. When unfilled orders accumulate, the price often retraces to these levels to execute the remaining trades, creating opportunities for traders to capitalise on these movements.

Fair Value Gap Example: Ethereum (ETH/USDT)

In the Ethereum (ETH/USDT) 1-hour chart, a clear fair value gap is evident in the recent price action.

During a volatile period, Ethereum experienced a sharp upward movement, followed by a retracement into a previously untraded zone. This demonstrated the concept of price imbalances and their role in trading strategies.

The FVG formed after a strong, bullish move on December 16, 2024. Ethereum’s price surged from approximately $3,800 to $4,000, leaving a gap in the range of $3,860 to $3,950. This zone represents an imbalance caused by aggressive buying, where price action skipped over certain levels due to overwhelming demand.

In the following sessions, Ethereum’s price began to retrace from its highs around $4,100, heading back toward the FVG zone. On testing the gap, the price entered the imbalance area, briefly consolidating before resuming its upward trend.

What Causes a Fair Value Gap?

Fair value gaps are the result of rapid price movements that create imbalances in the market. These gaps can be caused by news, big trades, or even low activity in the market. Let’s look at the main reasons why FVGs happen.

Sudden Market Volatility

Prices can move fast when the market becomes very active, leaving gaps behind. This usually happens during big news events, like economic announcements or political changes, or when markets open after the weekend. For example, if a company reports much higher profits than expected, its stock price might jump quickly, leaving an FVG.

Large Trades by Big Players

Big institutions, like banks and hedge funds, often trade huge amounts of money. When they buy or sell a lot at once, prices can skip levels because there aren’t enough orders to balance out the move. These big players can also create gaps on purpose by pushing prices to trigger stop-loss orders from smaller traders.

Breakouts from Consolidation

When the price has been stuck in a tight range for a while and then breaks out, an FVG can form. This happens because many traders jump into the market at the same time, causing a rapid price movement. For example, if a stock has been trading between $50 and $55 and breaks above $55, the price might quickly jump to $60, leaving a gap.

Low Liquidity

When there are fewer traders in the market, prices can move unpredictably. This is common during holidays, weekends, or late-night trading hours. Fewer buy and sell orders are available, so prices skip over certain levels, creating FVGs.

Algorithmic Trading

Many trades today are made by computers using algorithms. These programs react to market changes in milliseconds, much faster than humans can. This speed can cause prices to move very quickly, leaving gaps as the market adjusts to the algorithms’ activity.

How to Identify a Fair Value Gap

Spotting FVGs requires attention to price charts and a clear understanding of candlestick structures. Here’s how you can identify them:

• Observe Candlestick Patterns: Look for areas where a candlestick’s wick or body does not overlap with the adjacent candlestick’s wick or body.
• Choose the Right Timeframe: FVGs appear across timeframes, but their significance varies. Larger gaps on daily or weekly charts often carry more weight than smaller gaps on intraday charts.
• Use Technical Tools: Indicators such as the Fair Value Gap Indicator automate the identification of gaps, saving time and reducing errors. These tools highlight gaps directly on your chart, making it easier to incorporate them into your analysis.

How to Trade Fair Value Gaps

Fair value gaps can help traders find good market opportunities. Below, we’ll explore strategies for trading FVGs, including how to enter and exit positions, enhance setups with other indicators, and manage risk effectively.

Entry and Exit Strategies

Trading fair value gaps revolves around timing your entry and exit. The fundamental idea is to wait for the price to revisit the FVG, which typically serves as a zone of support (for bullish gaps) or resistance (for bearish gaps).

For example, in a bullish FVG, the price moves upward rapidly, leaving a gap that it later retraces to before resuming its uptrend. A trader can place a buy order within the gap, expecting the price to bounce back up. Conversely, in a bearish FVG, the price retraces into the gap after a sharp drop, providing an opportunity to sell before the downtrend resumes.

When exiting trades, you can aim for the midpoint of the gap or the far edge, depending on how far you think the price will move. You can also use a trailing stop, which moves up as the price rises, to lock in profits while letting the trade grow.

Combining FVGs with Indicators

While FVGs are powerful standalone signals, their effectiveness can be amplified by combining them with other technical analysis tools. This approach provides additional layers of confirmation and reduces the likelihood of false signals.

• Moving Averages: Moving averages, such as the 50-period or 200-period SMA, can help identify the overall trend. For instance, if a bullish FVG forms above an upward-sloping 50-period SMA, the odds of a successful trade increase significantly.
• Relative Strength Index (RSI): RSI is particularly useful for spotting overbought or oversold conditions in conjunction with FVGs. A bullish FVG in an oversold market (RSI below 30) signals a high-probability buying opportunity, while a bearish FVG in an overbought market (RSI above 70) strengthens the case for a sell.
• Fibonacci Retracements: FVGs often align with Fibonacci levels, such as the 61.8% retracement, which adds another layer of validity. For example, if a bullish FVG overlaps with a Fibonacci level in an uptrend, it becomes a stronger zone for entering a long position.

Managing Risk When Trading FVGs

Even the most promising FVG setups can fail, which is why risk management is paramount. A disciplined approach ensures that losses are kept in check and profitable trades outweigh them over the long term.

• Stop Loss Placement: A well-placed stop loss is essential to protect against unexpected price movements. For bullish FVGs, the stop loss should typically be set just below the lower boundary of the gap. For bearish FVGs, it should be placed above the upper boundary.
• Position Sizing: The size of your trade should reflect your overall account size and risk tolerance. Many traders follow the 1-2% rule, risking no more than 1-2% of their total account balance on any single trade.
• Risk-Reward Ratio: Maintain a favourable risk-reward ratio, typically 1:2 or higher. This means that the potential reward for every $1 risked should be at least $2. For example, if your stop loss is $50 away, your target should be at least $100 to justify the trade.

Advantages of Fair Value Gap Trading

FVGs are widely regarded as powerful tools for both novice and experienced traders. Here’s why:

• Precision in Identifying Entry and Exit Points: FVGs provide clearly defined areas of interest on a price chart, allowing traders to pinpoint where the price will likely retrace or reverse. This precision can lead to better entry and exit timing than more generalised indicators like moving averages or trendlines.
• Easy Integration with Other Strategies: FVGs can complement other technical tools such as Fibonacci retracements, RSI, and moving averages. This makes them a flexible addition to a trader’s arsenal, enhancing the accuracy of predictions.
• Applicability Across Multiple Timeframes: FVGs appear on all timeframes, from intraday charts for scalpers to weekly charts for long-term traders. This versatility makes them suitable for a wide range of trading styles.
• Improved Risk-Reward Ratios: By focusing on retracements into FVG zones, traders often enter trades at more favourable prices, reducing risk while increasing the potential reward. For example, a trader entering within a bullish FVG at a lower price can set a closer stop-loss and aim for a larger profit.

Disadvantages and Challenges of Fair Value Gap Trading

While FVGs are beneficial, there are several challenges traders must be aware of to avoid costly mistakes:

Vulnerability to “Smart Money” Manipulation

Fair Value Gaps are often exploited by smart money—large institutions, hedge funds, or professional traders—who have the resources and expertise to manipulate retail traders. These players are aware that many retail traders use FVGs to identify potential retracement zones, and they often use this knowledge to create false moves, forcing retail traders out of their positions before the actual price movement occurs.

Additionally, smart money primarily operates on higher timeframes (e.g., daily or weekly charts). This difference in focus can lead to retail traders placing trades on gaps that lack significance in the broader market context.

Requires Patience and Timing

FVG trading often involves waiting for price retracements to fill the gap, which can take time and test a trader’s patience. Impulsive traders may enter too early, anticipating a retracement, only to see the price continue moving against them. Similarly, waiting too long can cause traders to miss out on the ideal entry point altogether.

Not Reliable in All Market Conditions

FVGs are most effective in trending or volatile markets, where imbalances are more likely to be filled. However, price action may ignore FVG zones entirely when consolidating or in range-bound markets, making this strategy less reliable. For instance:

• In a strong uptrend, bearish FVGs may not fill because the buying pressure is too overwhelming.
• During low-volatility periods, the price may hover near an FVG without fully retracing or bouncing.

Difficulty Identifying Significant FVGs

Not all FVGs are equally important. Beginners often struggle to differentiate between meaningful gaps and minor imbalances that are unlikely to impact price. This can lead to overtrading or focusing on gaps irrelevant to the broader market context.

Prone to False Signals

Price retracing into an FVG doesn’t always guarantee a bounce or reversal. Traders can experience false signals where:

• Price enters the gap, giving the impression it will fill or reverse, but instead continues in the opposite direction.
• The gap gets partially filled but fails to generate a meaningful move, leading to premature exits or stop-outs.

False signals are particularly common in highly volatile markets or during times of market indecision.

Psychological Pressure and Overtrading

FVGs frequently appear on smaller timeframes, tempting traders to overtrade by chasing every setup they see. This can lead to exhaustion, higher transaction fees, and a lack of focus on quality setups. Furthermore, the frequent stop-outs that can occur with poorly placed FVG trades may frustrate traders, leading to emotional decisions and compounding losses.

Conclusion

Trading fair value gaps can be a versatile strategy that can enhance your trading precision. To succeed, always approach FVG trading with a comprehensive plan, incorporate risk management, and remain mindful of broader market conditions. Start by practising with demo accounts to refine your skills before trading with real capital.