In trading, price doesn’t always move smoothly. Sometimes, the market skips levels, leaving gaps behind. These are called imbalances and fair value gaps. If you’ve ever seen the price of a stock jump from one point to another without filling in the middle, you’ve witnessed a price gap. Understanding how these gaps form and how Smart Money (big financial institutions) fills them is crucial for traders who want to anticipate market movements.
In this blog, we will explain what imbalances and fair value gaps are, why they happen, and how traders can use this knowledge to make better decisions.
Table of Contents
What is an Imbalance?
Imagine walking on a beach and leaving footprints in the sand. Normally, your steps are evenly spaced. But sometimes, if you take a giant leap, there’s a big gap between your footprints. In the market, this big gap is called an imbalance. It’s a place on the price chart where there are more buyers than sellers, or vice versa, creating a gap in the price movement.
In simple terms:
- Imbalance: A price level where buying or selling happened too fast, leaving a gap on the chart.
When the market moves too quickly in one direction, it creates an imbalance because there wasn’t enough trading (or liquidity) at that price level. Later, the market often comes back to fill this gap, like retracing steps to fix what was missed.
What is a Fair Value Gap (FVG)?
A Fair Value Gap (FVG) is a specific type of imbalance. It happens when the market moves so fast that it doesn’t give traders enough time to enter or exit trades at a fair price. Think of it as the market jumping from one level to another without completing its usual process.
Let’s break it down:
- Fair Value Gap: A price range where the market did not trade enough, causing a gap between buyers and sellers.
For example, if the price of an asset suddenly jumps from $100 to $105 in a single move, without trading much between $100 and $105, this creates a fair value gap. The market often comes back to this gap to allow more trading to happen at fair prices.
Why Do Imbalances and Fair Value Gaps Happen?
Imbalances and fair value gaps occur because the market is driven by supply and demand. If there’s a sudden surge in buying or selling, the price moves too fast, leaving gaps. Here are some reasons why this happens:
- Big News Events: When major news comes out, like an earnings report or government announcement, prices can move sharply in one direction.
- Smart Money Influence: Large institutions (Smart Money) place huge orders that can move the market quickly, creating gaps.
- Low Liquidity: When there aren’t enough buyers or sellers, the market has to jump to the next level where there’s more interest.
How to Spot Imbalances and Fair Value Gaps on a Chart
Now that you know what imbalances and fair value gaps are, how can you find them on a price chart? It’s pretty simple!
Spotting Imbalances
- Look for price movements that happen too quickly in one direction.
- Imbalances often show up as large candles (bars) on the chart, where there wasn’t much trading in the middle.
Spotting Fair Value Gaps
A fair value gap is seen when there’s a gap between three candles:
- The first candle moves in one direction (up or down).
- The second candle creates the gap.
- The third candle doesn’t fully overlap with the first candle, leaving a space in between.
This gap is what we call the Fair Value Gap, and it’s an area where the market may come back to later.
Why Do Imbalances and Fair Value Gaps Matter?
Imbalances and fair value gaps are important because the market doesn’t like leaving gaps behind. When these gaps are left open, the market often retraces back to fill them. This is why traders who understand imbalances and fair value gaps can better anticipate when the market will reverse or retrace.
How Smart Money Fills the Gaps
Smart Money, like big banks and institutions, knows where these imbalances and fair value gaps are located. They use this information to plan their trades.
- Filling the Gap: Smart Money may push the market back to fill a gap. For example, if there’s an imbalance at $105, Smart Money might push the price back down to $105 to fill the gap before continuing in the original direction.
They know that these gaps are areas of interest for many traders, so they take advantage of them. Smart Money also uses these gaps to trap retail traders (smaller traders), making them think the market is going one way, only to reverse it once the gap is filled.
How to Trade Imbalances and Fair Value Gaps
Understanding imbalances and fair value gaps can help you become a better trader. Here are some strategies you can use:
1. Wait for the Gap to Fill
When you spot a fair value gap on the chart, be patient and wait for the price to come back to fill the gap. Once the gap is filled, the market often continues in its original direction.
- Example: If the price of a stock jumps from $100 to $105, creating a gap, wait for the price to come back down to $100-$102 to fill the gap before buying.
2. Use Imbalances to Identify Reversals
Imbalances can signal that the market is overextended and might reverse soon. When you see a large imbalance, watch for signs that the price will retrace to correct the imbalance.
- Example: If the price rises too quickly without enough trading in the middle, wait for a retracement back to that level before entering a trade.
3. Combine with Other Trading Concepts
Imbalances and fair value gaps work best when combined with other trading strategies, like Support and Resistance or Supply and Demand Zones. Look for gaps that line up with key levels on the chart for stronger confirmation.
- Example: If there’s a fair value gap at a support level, this is a strong indication that the market will come back to that level.
Common Mistakes to Avoid
Even though trading imbalances and fair value gaps can be profitable, there are some common mistakes that traders make:
- Ignoring the Trend: Don’t trade every gap you see. Make sure to trade in the direction of the trend. If the market is in an uptrend, focus on bullish (upward) gaps. In a downtrend, focus on bearish (downward) gaps.
- Entering Too Early: Be patient and wait for the gap to be filled before entering a trade. If you enter too early, you might get caught in a false move.
- Not Using Stop Losses: Always protect your trades with a stop loss. Gaps can sometimes fail to fill, and you don’t want to lose more than you’re comfortable with.
Conclusion
Imbalances and fair value gaps are like unfinished business in the market. They tell us where the price moved too quickly and where it might come back to fill the gap. By understanding these concepts, you can better anticipate market retracements and make smarter trading decisions. Always remember , trading is a high risk business so before entering read Risk Management Techniques for Trading & Financial Markets: A Beginner’s Guide as well.
Remember:
- Imbalances are areas where the market moved too fast, creating a gap.
- Fair Value Gaps are specific types of imbalances that Smart Money often fills.
- Smart Money uses these gaps to plan their trades and trap retail traders.
If you can spot these gaps and understand how Smart Money fills them, you’ll have a powerful tool in your trading arsenal. Practice looking for imbalances and fair value gaps on your charts, and soon, you’ll be able to trade like a pro!