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Understanding Imbalance and Fair Value Gaps (FVG)
Imbalance, often referred to as a Fair Value Gap (FVG), is a concept used in trading, particularly within the context of the Smart Money Concept (SMC). It represents areas on a price chart where the market has moved rapidly, leaving behind a gap that has not been filled by subsequent price action. This phenomenon occurs due to significant buying or selling pressure from large market participants, such as banks and institutional investors, leading to sharp price movements.
Key Characteristics of Imbalance
- Formation: Imbalances typically consist of three candles:
- First Candle: The starting point that creates the upper or lower boundary of the imbalance.
- Second Candle: The impulse candle, which shows the significant price movement in one direction (bullish or bearish).
- Third Candle: This candle closes and establishes the other boundary of the imbalance.
- Identification:
- Bullish Imbalance: Found between the highest point of the first candle and the lowest point of the third candle.
- Bearish Imbalance: Located between the lowest point of the first candle and the highest point of the third candle.
- Liquidity Consideration: Imbalances are often considered stronger if they follow a liquidity sweep, meaning that the price has previously collected liquidity above recent highs or below recent lows before the imbalance forms.
Importance of Imbalance in Trading
- Market Sentiment: Imbalances can give insight into the sentiment of large market participants.
- Price Movement: Prices often return to fill these gaps, making them potential areas for future price action.
Analyzing Imbalance for Trade Decisions
- Identify Recent Price Action: Look for rapid movements in price that create gaps between candles.
- Mark Imbalances: Identify the three-candle structure and mark the boundaries of the imbalance.
- Assess Liquidity: Consider whether the imbalance followed a liquidity sweep.
- Monitor for Price Reaction: Watch how the price interacts with the identified imbalance in future sessions.
Rules for Long Entries in Trading
There are two primary options for entering long trades:
- On the Trend’s Reversal
- After a Correction of the Trend
Both options can be effective, but they have minor differences in execution. Trend reversals can be more challenging to capture because the market often continues in the direction of the prevailing trend.
Long Entry on Trend Correction
This section focuses on entering long trades during trend corrections. Follow these steps:
- Wait for Strong Momentum: Observe the price moving higher with strong momentum, resulting in the formation of a Fair Value Gap (FVG).
- Liquidity Pool Collection: It’s advantageous if the price collects a liquidity pool before making a further upward move.
- Enter the Trade: Wait for the price to retrace into the FVG. This is your entry point for opening a long trade.
- Set Stop Loss: Place your Stop Loss below the last swing low to protect your trade from unexpected market moves.
- Set Take Profit: Target a Take Profit level above the recent high to maximize your potential gains.
- Risk-Reward Ratio: Ensure that you maintain a decent risk-reward (RR) ratio. A ratio of 1:3 is often considered ideal. If the potential reward is lower, it may be wiser to skip the trade.
Example of a Long Trade
In the above example, we open a trade in the middle of the FVG as indicated in the upper chart to achieve a 1:3 RR ratio. This setup illustrates the effectiveness of entering during a trend correction, capitalizing on the momentum and the established gap.
Rules for Short Entries in Trading
There are two primary options for entering short trades:
- On the Trend’s Reversal
- After a Correction of the Trend
Both options can be effective, but they have minor differences in execution. Trend reversals can be more challenging to capture because the market often continues in the direction of the prevailing trend.
Short Entry on Trend Correction
Follow these steps to enter a short trade during a trend correction:
- Wait for Liquidity Sweep: Monitor the price for a sweep of the closest liquidity pool, which should precede a reversal.
- Formation of FVG: Ensure that the price leaves a Fair Value Gap (FVG) behind as it reverses.
- Enter the Trade: Wait for the price to reach the FVG. You can enter the trade as soon as the price touches the imbalance or wait for it to fill the entire gap, depending on your risk management strategy.
- Risk-Reward Ratio: Ensure your risk-reward (RR) ratio is at least 1:3 before entering the trade. If it is lower, consider skipping the entry.
- Set Stop Loss: Place your Stop Loss above the recent high to manage risk effectively.
- Set Take Profit: Target your Take Profit near the liquidity pool or at the lower end of the FVG, as these are likely price magnets.
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