If you’ve been trading for a while, you’ve probably heard the term “fair value gap”. It might sound a bit confusing at first, but it’s actually pretty simple once you get the hang of it. Let’s break it down and see how it can affect your trading.
What is a Fair Value Gap?
A fair value gap happens when there’s a big difference between the number of buyers and sellers. This usually occurs during times when the market is very busy, like after big news events. When everyone suddenly starts buying or selling, prices can move quickly, creating a gap where there wasn’t much trading.
Think of it like an auction where everyone suddenly starts bidding at once. The price jumps up quickly because there’s so much demand. In trading, this quick price movement creates gaps on the chart, where prices jump from one level to another without any trades happening in between.
How to Spot Fair Value Gaps
To find a fair value gap, look for big price jumps on a chart. These gaps usually show up after a sharp price move when the market doesn’t have time to fill in all the price levels. For example, if a stock jumps from $100 to $105 quickly, there might be a gap between $101 and $104 where few trades happened.
You can find these gaps in all markets, like stocks, forex, and commodities. They are easiest to see on short time frames, like 1-minute or 5-minute charts, but they can also show up on longer time frames during busy periods.
Why Do Fair Value Gaps Matter?
Understanding fair value gaps can help you make better trading decisions. These gaps often act like magnets for price, meaning the market tends to revisit these areas to fill the gaps. This happens because the market tries to balance out the number of buyers and sellers. When there’s an imbalance, like a fair value gap, the market often moves back to these levels to even things out.
For traders, this means that fair value gaps can be good places to enter or exit trades. If you see a gap that hasn’t been filled yet, there’s a good chance the price will move back to that level at some point, giving you a chance to trade.
Trading Strategies Using Fair Value Gaps
- Gap Filling Strategy: One way to trade is to wait for the market to return to the fair value gap. For example, if a stock jumps from $100 to $105 and leaves a gap between $101 and $104, you might wait for the price to drop back to $102 to buy. The idea is that the gap will act as a support level, giving you a good entry point.
- Breakout Strategy: Sometimes, the price doesn’t return to fill the gap and keeps moving in the same direction. In this case, you might trade when the price moves above the high of the gap for a buy trade or below the low of the gap for a sell trade. This works well when strong news pushes the price further in the same direction.
- Stop-Loss Placement: Fair value gaps can also help you decide where to place your stop-loss orders. If you’re buying based on a gap fill, placing your stop just below the gap (in a buy trade) or above the gap (in a sell trade) can give you a logical exit if the market doesn’t go as expected.
Risks and Considerations
While trading fair value gaps can be profitable, it’s important to know the risks. The market doesn’t always fill gaps right away, and it can sometimes take days, weeks, or even longer. Also, during busy periods, the market can move past gaps, causing unexpected losses if you’re not careful.
To reduce these risks, always use proper risk management. This includes setting stop-loss orders, managing your trade size, and paying attention to overall market conditions. It’s also a good idea to use fair value gap strategies with other analysis tools to increase your chances of success.