If you are a price action trader, you may be familiar with a concept that has been making the rounds lately called the fair value gap. In this article, we’ll talk about the basics of the fair value gap, and show some examples of how to consider using it in your trading, as well as how to search for it on the TrendSpider platform. Let’s dig.
Understanding the fair value gap
Before we get into how to use the fair value gap indicator in your trading, let’s first talk about what the fair value gap is.
Fair value gaps are commonly used among price action traders and are defined as situations where there are inefficiencies or market imbalances. These “imbalances” simply indicate that buying and selling are not equal.
Fair value gaps are created within a three-candlestick sequence and are usually visualized on the chart as a large candlestick whose upper and lower wicks of the adjacent candles do not completely overlap with the larger candle.
The reason why a trader is interested in where fair value gaps occur is simply that the resulting imbalance can become a price magnet in the future.
Fair Value Gap Index
Like any other indicator on the TrendSpider platform, the Fair Value Gap indicator can be added to your charts by selecting it inside your indicators button. Once added, it will highlight all the fair value gaps on your chart with blue horizontal shaded areas, as shown in the image below.
Trading the fair value gap
In the example shown below, we see a top made followed by a strong sell-off. The first big red candle after the top is where the fair value gap is created. The price trades down, starts forming a bottom and then rises again to test the previous high that was made. Once the fair value gap is closed, the price starts selling again. This could be an example of price filling to the upside to remove the imbalance caused by the fair value gap. Once the gap is closed, there is no longer an imbalance and the price can continue in the direction it was heading previously and a secondary downward movement occurs.
In the example below, we see the opposite of the example above. The fair value gap arises due to strong buying pressure. The price trades up, starts to rise and then falls back into the fair value gap. This removes the imbalance created from the rally, and after the gap is filled almost immediately, the price can continue to rise.
Finding the fair value gap
Although it is not currently possible to use the fair value gap indicator in the scanner, it is still possible to search for fair value gaps using price action criteria. As we defined earlier in the blog, fair value gaps are formed across a three-candlestick sequence where the upper and lower wicks adjacent to the large candlesticks do not completely overlap the large candle.
In the event of a fair value gap due to significant purchase pressures, we will use the following criteria:
- Low (last) is greater than High (two candles ago) – this determines that there is no overlap between candle wicks
- price. The close (before one candle) is greater than the price. Open (before 1 candle) at least “x%” – this determines significant buying pressure
- Price: Close (before 1 candle) is greater than the price. High (2 candles ago) – this determines that the candle with buy pressure closed above the high of the previous candle
In the event of a fair value gap due to significant selling pressures, we will use the following criteria:
- Price is high (finally) lower than price is low (2 candles ago) – this determines that there is no overlap between candle wicks
- Price: The closing price (before one candle) is lower than the price. Open (before 1 candle) at least ‘x%’ – this determines significant selling pressure
- Price: the closing price (1 candle before) is lower than the low (2 candles ago) – this determines that the candle with selling pressure closed below the low of the previous candle
The image below shows these parameters written into the TrendSpider scanner.
If you are an existing TrendSpider user, you are welcome to subscribe to this common fair value gap scanner. Keep in mind that this scanner looks for fair value gaps created in both uptrends and downsides. If you want to use specific scanners for each direction, save the sets of conditions and create your own! In addition, feel free to create your own version and modify the parameters as you see fit.
If you prefer to learn via educational videos, we are happy to provide a companion video for this blog!
So there you are, people. Some basic ways to think about how to take advantage of the fair value gap in your technical analysis and within the TrendSpider platform. We hope you found this helpful and we’d love to hear how you use this indicator! Feel free to reach us in chat with any questions or ideas you may have.