Fair Value Gaps: A Deeper Dive

The popularized Approach to FVG - based on time (Regular candlesticks)

Fair Value Gaps (FVGs) are a key concept in price action trading, especially in the world of institutional trading strategies. They represent inefficiencies in the market where price has moved too quickly for all orders to be filled, leaving gaps that the market often seeks to fill. This educational post will explain what Fair Value Gaps are, why they matter, the different types of FVGs, and how traders can use them effectively.

What Are Fair Value Gaps?

A Fair Value Gap occurs when there is an imbalance in the price action, typically between three candles. The most basic Bullish FVG forms when the high of candle 1 does not overlap the low of candle 3, creating a gap. The most basic Bearish FVG forms when the low of candle 1 does not overlap the high of candle 3, creating a gap. These gaps represent areas where large institutions or smart money have left behind unfilled orders due to aggressive price movement.

Why Fair Value Gaps Matter

Market Influence & Price Rebalancing

FVGs reflect the actions of smart money traders. When price leaves behind an imbalance, it indicates that large orders haven't been fully absorbed.

One key aspect of Fair Value Gaps is their ability to signal that the market may return to a specific level in order to "balance" itself. Since price usually moves in a more orderly manner when liquidity is balanced, these gaps highlight areas of potential retracement.

Key Trading Zones

FVGs often act as key trading zones, functioning similarly to support and resistance levels. When price retraces to fill these gaps, it can provide entry opportunities with defined risk.

Read more about the popularized FVG used in Smart Money Concepts Trading.

The Truth About What FVG Really Is Based on Tick Charts

When looking at time-based charts today, it's easy to notice that there are numerous Fair Value Gaps (FVGs) based on the traditional concept of imbalances in price action. Some of these gaps are filled and respected, while others seem irrelevant and are ignored by the market. This raises a crucial question for traders: How can you know which FVGs to rely on? And more importantly, how can you identify the most reliable ones? To answer these questions, we must first understand the truth behind a Fair Value Gap and its key characteristics.

Fair Value Gaps (FVGs), as introduced by ICT (Inner Circle Trader), have become a widely used concept among traders, particularly in price action and smart money trading strategies. However, it's essential to understand that FVGs are fundamentally just a price action pattern with a specific name, rather than a guaranteed signal of institutional activity or unfilled orders.

In this explanation, I'll uncover the true nature of what an FVG really is and what it represents. But before we dive deeper, we need to explore Tick Charts and how they differ from regular time-based candlestick charts.

What is a Tick Chart?

A tick chart is a type of chart used in financial markets that plots price movements based on a fixed number of transactions (or "ticks") rather than over a fixed period of time, as in traditional time-based charts. Each bar (or candlestick) on a tick chart represents a specific number of trades or transactions, regardless of how much time has passed. For example, a 200-tick chart will plot a new bar every time 200 trades occur, regardless of whether it takes 10 seconds or 10 minutes.

Key Features of Tick Charts:

1. Trade-Volume Based: Unlike time charts, where a new candlestick is created after a fixed time interval, tick charts only print a new bar after a specified number of trades have been completed.
2. More Detailed During High Activity: During periods of high trading activity (such as during news releases or market open), tick charts print bars more frequently, showing the price action in finer detail.
3. Less Noise in Low Activity: In slow market periods, tick charts will print fewer bars, helping to filter out unnecessary price movement "noise."

How Tick Charts Compare to Regular Candlestick Charts (Time-Based)

Time vs. Volume

• Time-Based Charts: Each candlestick is created based on a fixed time period (e.g., 1 minute, 5 minutes, 1 hour). This means that regardless of how much trading occurs, a new bar will form at the end of each time interval.
• Tick Charts: These charts are independent of time. Instead, they are based purely on the number of trades (or "ticks"). A new bar is created only after a set number of transactions have occurred.

In summary, tick charts are ideal for traders looking for a real-time, transaction-based view of the market, providing detailed price action during high volume periods while filtering noise during low volume. Time-based candlestick charts are better for traders focused on broader trends and longer-term analysis, offering consistent updates based on time intervals.

Understand what FVG really is

To fully understand what a Fair Value Gap (FVG) is, it's important to study price action from a tick chart perspective. This is because tick charts reflect the actual trades and the precise prices at which orders are placed and executed, something that cannot be captured as accurately with time-based candlesticks. Time-based charts do not reveal the detailed execution of trades, especially during periods of high market activity.

An FVG on a tick chart is essentially the same as a price gap on a time-based chart. Most traders are familiar with the concept of a gap: it's the unfilled space between the close of one candle and the open of the next. In traditional trading, this is simply referred to as a "gap."

If we look at an FVG on a 1-minute chart, it appears when the highs and lows of consecutive candles don't overlap, creating an imbalance between the two bars. However, since the candle on a time-based chart forms over a set period (in this case, 1 minute), it closes at a fixed time, regardless of how many trades occurred within that timeframe. This makes it impossible to fully understand how price moved within that 1-minute candle and at what specific prices trades were executed.

What looks like an FVG on a time-based chart might not be an FVG at all when viewed on a tick-based chart. Tick charts provide a more granular view, showing the exact moments where price imbalance or inefficiency occurs. Inside a time-based candle, trades could have been executed at prices where liquidity was high, meaning price action was efficient, and therefore, it shouldn't be classified as an FVG. Since FVGs are meant to highlight inefficiencies in trading, where price moves too quickly without sufficient liquidity, tick charts offer the best way to identify genuine imbalances that might not be visible on regular charts.

On the 1-minute chart, we see a lot of FVGs in this drop. However, when we look at the tick chart for the same drop, we can see that the price moved steadily with high efficiency and liquidity during this decline. Hence, the Fair Value Gaps on the 1-minute chart are irrelevant. The market was efficient during this drop.

Example of a True FVG

To truly identify inefficiencies in the market, it's essential to study price action using a tick-based chart. This is because tick charts are the only way to see the exact price levels at which trades were executed.

In the image below, we see an example of a tick chart, where each candlestick represents a fixed number of transactions, in this case, two trades. Unlike time-based charts, which generate a new bar after a set period (such as every minute or hour), tick charts create a new bar after a specified number of trades have occurred, regardless of how much time has passed.

To spot inefficiencies or Fair Value Gaps (FVGs),  we need to look for price areas where large gaps occur in the tick-based chart; in other words, price differences that are larger than the average spread. These gaps indicate that buyers and sellers were too far apart to complete a balanced transaction. In such cases, either the buyer or seller had to accept the other side's price, leaving a gap that represents an imbalance or inefficiency in the market.

In essence, an FVG is simply a price gap in a tick-based chart. These gaps show where the market moved too quickly, leaving untested price levels, which may lead to future price retracements as the market seeks to "fill" these gaps.

Spotting True Fair Value Gaps Without Tick Data

Standard Fair Value Gap (FVG)

Read more about it here

Breakaway FVGs

This type of gap occurs when price "breaks away" from a previously established price range, often due to a strong trend or the breakout of consolidation zones. Breakaway gaps can act as areas of interest, where traders expect the market to fill part of the gap before resuming the new trend.

• How to use it: If you catch a breakaway gap early, it can signal the start of a new trend. Traders often wait for price to retrace partway into the gap, entering positions in the direction of the breakout.

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Measuring FVGs

These gaps typically occur in the middle of a significant price move and act as a continuation signal. Measuring gaps are often seen in trending markets. An essential characteristic for a measuring FVG is the presence of a sharp, impulsive price movement. Without this, the gap might not be considered a valid continuation signal.

• How to use it: When identified, traders can use these gaps to project where the price may retest and to gauge whether the trend remains strong. These are common in swing trading setups.

Exhaustion FVGs

Exhaustion gaps usually signal the end of a strong trend. They appear after an extended move in one direction and indicate that momentum is waning. As the trend loses steam, the market often seeks to fill this gap as participants start taking profits and liquidity returns to the market. High volume is usually observed at exhaustion gaps, as this represents a final surge of activity before a trend reversal. A Break of Market Structure (BMS/BoS) must have occurred recently to validate the Fair Value Gap.

• How to use it: Look for an exhaustion gap in overextended trends, often accompanied by a volume spike, as it suggests that a reversal is imminent. Traders can use this as a signal to either fade the current move or lock in profits.

Liquidity FVGs

These gaps often appear in highly volatile markets where the price rapidly moves in one direction, leaving behind large gaps. Liquidity gaps reflect a scenario where large institutional orders have been placed but not fully filled, leading to a temporary price imbalance.

• How to use it: Liquidity gaps are often strong reversal signals as the market tends to return to these zones to fill orders. Traders should look for these imbalances during high-impact news events or market open sessions where liquidity is thinner.

Why Are There So Many Different Types of FVGs?

The existence of various types of fvgs reflects the diversity of market behavior and the forces that influence price movement. Each type of gap represents a different market condition, whether it's a trending market, a volatile news release, or ranging markets etc.

How to Use Fair Value Gaps Properly in Trading

While recognizing fvgs is important, knowing how to leverage them in your trading strategy is crucial. Here are some key guidelines:

1. Confluence with Key Levels: Fair Value Gaps work best when they align with other technical tools like support/resistance levels, Fibonacci retracement zones, or trendlines. Look for confluence between the gap and these levels to increase the probability of a successful trade.
2. Wait for Confirmation: Don't jump into a trade simply because a imbalnce exists. Wait for retest so that the price can fill the gap.
3. Consider the Timeframe: Gaps on larger timeframes like the 1-hour or daily charts tend to have more significance and staying power than those on lower timeframes like the 5-minute chart. However, lower timeframe gaps can still be valuable for scalping or short-term trades, as long as they are used in conjunction with trend direction.
4. Context Matters: Not all gaps are meant to be filled immediately. Some gaps, like breakaway or measuring gaps, may only be partially filled or act as continuation signals. Always assess the context of the gap within the overall market structure.

Conclusion

Fair Value Gaps offer traders valuable insights into price imbalances and can highlight potential trade opportunities. By understanding the different types of FVGs, such as standard fvgs, liquidity fvgs, breakaway fvgs, and more, traders can refine their strategies and better anticipate market behavior. The key is to use gaps in combination with other technical analysis tools and ensure that trades are taken with proper confirmation and context.

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