Fair Value Gaps (FVG) Explained
In the trading of stocks and currencies, the use of fair value gaps in trading strategies has recently grown. Fair value gaps are a price action concept popularized by the ICT (Inner Circle Trader). They locate areas of imbalance on a chart where traders can enter positions to profit. In this article, we cover what FVGs are, how to locate them, the best strategies for using them, and the theory behind them.
What is a fair value gap (FVG)?
An FVG on a chart identifies an area where the fair price of an asset has recently changed. This change implies that when the price returns to where the FVG had just formed, it will either rise if it is a bullish FVG or fall if it is a bearish FVG. This concept is similar to that of supply and demand zones or support and resistance lines; however, FVG's form faster, giving those traders using them an advantage.
How to identify an FVG
FVG's are a three candle pattern. Identify a candle that is large relative to the candle on its left and right.
Find a bullish FVG
Identify a green candle that is large relative to the candles on its left and right.
The high value of the candle on the left of the large candle (1) should not overlap with the low value of the candle on the right (2).
Draw a box, where the bottom is the left candle's high (4) and the top of is the right candle's low (3). Extend the box out to the most recent candles. This box forms a bullish FVG.
When price falls and enters this zone, it is likely to reverse and rise again. If price falls past a bullish FVG zone's bottom, that FVG is invalid and should no longer be used.
Find a bearish FVG
Identify a red candle that is large relative to the candles on its right and left.
The low value of the candle left of the large candle should not overlap with the low of the candle on the right of the large candle.
Draw a box where the top of the box is the left candle's low and the bottom of the box is the right candle's high. Extend the box out to the most recent candles. This box forms a bullish FVG.
When the price rises and enters this zone, it is likely to reverse and fall. If the price rises past a bearish FVG zone's top, that FVG is invalid and should no longer be used.
What is the theory behind FVGs?
Typically, a large spike in price is a large buy order being executed. This large spike enables those people holding positions to exit for a profit at the higher price, which causes prices to fall after the spike. However, when large increases in price occur and price does not move down after, instead further increasing, we can assume that those people holding positions believe that this new price is safe for them to continue holding or even buy more.
Let us say that a stock is fluctuating between 9-10$. You purchase the stock at 9$ and are waiting for the stock to move back to 10$ to sell. News is released about the stock, and it shoots up to 11$. You and all the other people who were holding positions previous to the spike continue to hold, as you believe that the stock will now further increase. This means that the fair value of the stock has changed from 9-10$ to 10-11$. People now are willing to purchase the stock for around 10-11$, whereas before it was 9-10$. If the price rises and then moves back down to between 10-11$ people will start buying and driving it back up.
The first high of the candle to the left of the large spike candle represents the bottom of the new fair value, while the candle to the right of the large spike candle represents the high of the new fair value.
If the low of the last candle overlaps the high of the first, it means that enough people sold during the price shift to drive the price down to within the old fair value, meaning that there is insufficient confidence in the new increase for it to be considered a new fair value.
What time frames are best for fair value gaps (FVGs)?
Intraday time frames are best. Intraday means time frames less than one day, for example, 3 minute, 5 minute, and 15 minute time frames.
What stocks or securities are best for fair value gaps (FVGs)?
Fair value gaps can be used on any stocks, but stocks with a high trading volume, meaning a large number of people who are actively trading the stock, are best. This is also true for crypto currencies and futures.
How accurate are fair value gaps (FVGs)?
Fair value gaps are identified using a three candle pattern. This means that they form more quickly than other signals, but they can be less accurate.