Fair Value Gaps (FVGS): The Hidden Imbalances That Drive Market Retracements

What is a Fair Value Gap (FVG)?

A Fair Value Gap occurs when price moves too rapidly in one direction, creating an imbalance in the market. This imbalance represents an inefficiency, where one side of the market—either the buy or sell side—dominates without sufficient matching orders on the opposite side.

Imagine price rapidly moving up, leaving a gap between candlesticks where there was no real participation from sellers. This gap becomes an FVG, signaling that price may return to that area to "fill" the imbalance and restore equilibrium. Traders who understand this can use FVGs to anticipate price retracements and optimize their entry and exit points.

The Anatomy of a Fair Value Gap

An FVG can be visualized by examining three consecutive candlesticks on a chart:

1. Initial Candle: A strong bullish or bearish candle that drives price up or down rapidly.
2. Middle Candle: The following candle continues in the same direction but with an extension that leaves part of the previous candle’s body uncovered.
3. Third Candle: If the next candle fails to overlap or fill the gap created between the first and third candle, an FVG is confirmed.

This unfilled space signals an imbalance in price delivery, highlighting where there was only one-sided liquidity (e.g., only buyers or only sellers). The market often seeks to rebalance these gaps, creating opportunities for traders to anticipate where price is likely to revisit.

Types of Fair Value Gaps

FVGs can be categorized based on the side of the market that shows inefficiency:

• Buyside Imbalance, Sellside Inefficiency (BISI): This type of FVG forms when price moves up rapidly, leaving a gap where there was inadequate selling pressure. It indicates an area where price may retrace to fill the imbalance by facilitating more selling activity.
• Sellside Imbalance, Buyside Inefficiency (SIBI): Conversely, a SIBI occurs when price drops sharply, leaving a gap with insufficient buying interest. This signals an area where price may return to rebalance by attracting more buyers.

Why Do FVGs Matter?

Fair Value Gaps are significant for several reasons:

1. Algorithmic Footprints: FVGs are seen as the footprints left by institutions moving large volumes. These price gaps indicate where liquidity was insufficient, often due to sudden institutional buying or selling
2. Retracement Points: Price has a tendency to revisit these gaps as the market seeks equilibrium. This retracement is often used by institutional traders to re-enter or exit positions at fair value.
3. Support and Resistance Indicators: FVGs can act as temporary support or resistance levels. For instance, in a bullish scenario, a downward retracement into an FVG may meet buying interest, causing price to bounce and continue its upward trend.

Identifying FVGs on a Chart

To identify an FVG, follow these steps:

1. Scan for Strong Candles: Look for areas where price makes a significant move in one direction with large candles.
2. Check for Gaps: Identify if the subsequent candle leaves a space between the high of the first and the low of the third (or vice versa for a downtrend).
3. Mark the Zone: Highlight this gap zone on your chart as a potential area where price may return to fill the imbalance.

Using FVGs in Trading Strategies

Understanding FVGs can enhance your trading strategy in several ways:

1. Entry Points

A trader might wait for price to retrace into an FVG to enter a trade in the direction of the trend. For example, if a market is bullish and has left a buyside imbalance, entering a long position as price revisits the FVG can offer a favorable risk-to-reward ratio.

Example: In an uptrend, price quickly rallies, leaving a visible gap between two candles. The trader notes the gap as an FVG and sets a buy order at the lower end of the gap, expecting price to revisit and fill it before continuing higher.

2. Exit Points

FVGs can also signal strategic exit points. If you are in a trade and notice that price is approaching an unfilled FVG from the opposite direction, it might be a cue to take profit as price could stall or reverse when filling the gap.

3. Stop-Loss Placement

Placing a stop-loss just outside an FVG can protect against false breakouts and volatility. In a bullish trade, setting a stop-loss slightly below a bullish FVG ensures that if price breaks through and fails to respect the zone, your loss is minimized.

Combining FVGs with Other Tools

For best results, FVGs should be used alongside other technical analysis tools:

• Order Blocks: Pairing FVGs with order blocks can increase the reliability of a trade setup. An FVG located just above or below a valid order block may act as a high-probability zone for price reaction.
• Killzones and Timing: Time windows (e.g., London or New York Open) when price is most likely to move significantly can enhance the effectiveness of trading FVGs.
• Market Structure Analysis: Identify whether the broader market context supports a bullish or bearish view before trading an FVG. A clear trend or shift in market structure can provide additional confirmation for entries or exits.

A Practical Example of FVG Trading

Imagine price is in a strong uptrend and creates a buyside imbalance by moving sharply higher. Traders mark this FVG and wait for price to retrace. When price pulls back and touches the FVG zone, volume increases as buying resumes. The trader enters a long position, and price begins its upward continuation, fulfilling the expectation of filling and rebounding from the gap.

Common Pitfalls When Trading FVGs

While FVGs are powerful tools, traders should be aware of potential challenges:

• Over-Reliance: Don’t rely solely on FVGs for entries and exits. They are best used as part of a comprehensive trading plan.
• Ignoring Context: Always consider the broader market context. An FVG in isolation may not be as reliable if it contradicts the market’s primary trend.
• False Fills: Sometimes price may only partially fill an FVG or move past it, indicating that the market has different intentions.

Conclusion

Fair Value Gaps are more than just price anomalies; they represent algorithmic imbalances that offer critical insight into the behavior of smart money. By understanding how to identify and trade FVGs, traders can align their strategies with the footprints left by large institutions, thereby increasing their chances of success. Integrating FVGs into your trading plan—alongside tools like order blocks, market structure analysis, and timing strategies—can help you capture moves with greater precision and confidence.