As a passionate active trader making a full-time living from the markets, fair value gaps are one of the most reliable tools in my toolkit. When a gap occurs on high relative volume, signaling a mispricing and vacuum to soon fill, it telegraphs an impending volatility expansion to capitalize on.
In this comprehensive 2,000+ word guide, I will unravel everything you need to know to master fair value gaps and use them to snipe precision entries.
We‘ll cover:
- Why Gaps Occur
- Finding and Scanning Gaps
- Trading Strategies
- Common Mistakes
- Advanced Tactics
So buckle up! By the end, YOU will have the confidence to profit from gaps just like the pros.
What Causes Fair Value Gaps?
First, what dynamics in the market provoke these gaps to materialize in the first place?
Gaps form due to an imbalance between buying and selling pressure across key support and resistance zones. Specifically:
- Institutional algos and big money accumulate shares, absorbing orders BELOW key levels
- Meanwhile, retail traders and investing funds BUY shares ABOVE perceived value
This divergence extended over several bars allows price to stretch vertically before snapping back to fill the gap.
Here is what I mean…
[Diagram showing orders clustered around support/resistance levels, with price shooting up due to excess buying]Now, a gap will NOT occur from just any old selling/buying imbalance.
For an EXPLOSIVE gap, two elements must be in place:
Relative Volume Climax
First, the middle candle of the sequence needs an abnormal spike in volume. This indicates a climax shaking loose trapped orders.
Volatility Contraction
Second, volatility should be compressing leading up to the expansion.
This creates a "coiled spring" effect, with the gap signaling pending reversion back upwards or downwards!
Burn this sequence into your memory. VOLUME first draws my eye to a developing gap. Seeing low ATR contraction then confirms probability of a violent snap is high!
Scanning for Gaps in Real-Time
Rather than manually eyeball every chart, I leverage custom scans to detect gaps FOR me…
Here is simplified pseudocode logic feeding my real-time gap scanner:
Gap Upside:
If Current Low > Prev High by 2%
AND Prev Volume > 20d Average * 5
Then
Alert Symbol
Gap Downside:
If Current High < Prev Low by 2%
AND Prev Volume > 20d Average * 5
Then
Alert Symbol This scans every tick across 10,000+ symbols, firing alerts ONLY when both gap condition and high volume are detected!
It takes gap trading to an automated level only institutions previously had access to.
Now let‘s explore strategies to profit from these high probability signals!
Trading Strategies to Capitalize on Gaps
When an upside or downside gap occurs in a high relative volume area, I instantly label two zones:
Zone 1 – The open price INTO the gap
Zone 2 – The "bottom" or "top" defining the gap
Depending on market context, I will play the reversion in different ways:
Fading the Gap (Counter-trend)
If the larger trend is ranging or supportive zones appear, I will look to actively fade the gap by selling into Zone 1, targeting Zone 2.
This allows playing the snap-back for quick profits, rather than guessing further direction.
Entry: Limit sell order in Zone 1
Stop: Beyond Zone 1, or recent swing high/low
Target: Zone 2
Trading the Continuation
If gap forms IN THE DIRECTION of the trend,Zone 2 becomes my new floor for buying dips after partial gap fill.
This aims to hold for an extended runner in trend direction.
I scale in multiple targets:
Entry 1: Limit buy at Zone 2 after backtest
Entry 2: Add size if VWAP holds as new support
Targets: Take partial profits into Zone 1, let winners ride with trailing stop
Which style you trade depends on the market context and your overall bias. I suggest playing BOTH until you have a solid win rate experience with gaps!
Avoiding Common Newbie Mistakes
While gaps give us amazing risk/reward trading opportunities, you MUST avoid sabotaging yourself with rookie errors:
Trading the First Touch
New gap traders go straight LONG/SHORT on the first test of Zone 1 or 2.
This often results in stopping out for a loss before the actual fill!
Instead, wait for confirmation price is RESPECTING key zones before pulling trigger.
Not Using Stops
Failing to use protective stops is asking to be crushed for a crippling loss if gap retraces beyond expected.
Remember, gaps signal IMPENDING moves but don‘t guarantee things play out!
Forces Winners Too Early
Impatience causes beginners to cut winners WAY too early before a gap runner extends. Set initial targets then give room for trend to develop.
Lack of Context
Blindly trading every gap without considering indicatory or trend CONTEXT just burns money.
Not all gaps work out! Use higher timeframe structure to filter.
Avoiding these mistakes takes your gap trading consistency to the next level!
Advanced Gap Trading Tactics
While the basics can bring profits, next level traders up win rates using advanced tactics like:
Volume Profile Analysis
Volume nodes can forecast whether gaps will attract BIDS or OFFERS once price fills. This helps map pending liquidity.
[Chart showing developing Volume Profile highlighting liquidity zones to target]Divergences
Combining gaps with momentum divergences establishes probabilistic scenarios for aggressive entries.
If price shows bearish divergence INTO an upside gap, it signals immediate downside once fills!
[Embed chart highlighting bearish momentum divergence leading into gap downside move]Alternate Chart Timeframes
Sometimes gap sequences are MORE IMPACTFUL on higher timeframes like 1HR or daily charts.
Drilling down shows if buying/selling is short-term noise or reflects deeper institutional conviction.
I evaluate gaps top-down across 1M, 5M, 15M, 1HR windows based on asset volatility.
This gives me precision context to size positions accordingly.
Synthetic Shorting Gaps
To profit from downside gaps in assets WITHOUT short selling ability, I use leveraged inverse ETFs like SQQQ, SPXU and DOG.
These provide 2-3x exposure to shift long-only accounts.
[Examples of trading major gap downs using leveraged bearish ETF products]Still with me? By now you should have an expert-level grasp of trading gaps professionally. Let‘s wrap this up…
Final Notes
If you take only one lesson from this extensive guide, internalize this:
Fair value gaps produce targeted volatility expansions signaling impending order flow. By properly contextualizing, you snipe precision entries just as institutions do!
Now, gaps do FAIL occasionally. But played with discipline over a sample size of trades, they offer extremely favorable risk/reward ratios.
The profits ultimately outweigh the losses over time.
So start scanning tonight and be ready to pounce on the best gap setups this week! Please reach out with any other questions.
Your friend in trading,
[Your name]