Trading: An Inside Look. Module 6:Price Inefficiency
Module Plan
1. Terminology.
2. Efficient and Inefficient Pricing.
3. Fair Value Gap (FVG).
4. Rebalancing Process.
5. Types of Rebalance. Refill.
6. Conclusion.
1.Terminology
Balance — equilibrium.
Imbalance (imb) — lack of equilibrium. In the context of trading — price inefficiency.
Fair Value Gap (FVG) — a chart pattern indicating price imbalance.
Slippage — the difference in price that can occur between the time an order is placed and when it is actually executed.
Rebalance — the process of covering market imbalance. Re-testing the FVG zone.
IOFED (Entry Drill) — retesting the FVG with a “spike” without testing 50% of the FVG zone.
0.5 — covering 50% of the FVG.
Full Fill — complete covering of the FVG zone.
2. Efficient and Inefficient Pricing
Before starting the practical use of this tool in trading, it is necessary to understand the mechanics of market balance and imbalance in general.
The basis of any market, whether cryptocurrency, forex, or stock market, is built on free market relations, where supply and demand (buyers and sellers) prevail.
For someone to be able to buy, someone must sell, and vice versa. Accordingly, the number of buy and sell orders must be in equilibrium (balance). Such market conditions are efficient and occur most of the time.
In the schematic example above, we can see how the number of buy and sell orders is balanced at each price level.
At some price levels, we see a slight advantage of buys over sells, which causes the market to move smoothly in an upward direction.
During market balance, we do not see sharp impulsive movements in either direction, and the number of buy and sell orders in the order book is approximately equal.
Imbalance (imb) is a price inefficiency caused by an impulsive price movement due to an abnormal advantage of demand/supply at a price level.
Most often, these anomalies occur due to the triggering of orders from large market participants with large volumes.
Since the price does not encounter resistance from one of the sides in the form of orders, there is a sharp shift in price in the prevailing direction. In simple words, we see an imbalance between buyers and sellers. This process can occur within a few minutes, as well as over several hours, days, or weeks, so we can consider inefficiency on different timeframes, because the price is fractal.
Schematic Example of Imbalance:
In the schematic example above, we can see how a large buy volume of 755 notional units (n.u.) appeared at the price level of 1100, which significantly exceeds the sell volume of 155 n.u.
To execute this large order, the market starts looking for offers at higher prices until it completely fills the required volume, which leads to an impulsive price increase.
At the price of 1100, 155 n.u. of volume is executed, the remaining 600 n.u. are filled at prices of 1200 (300 n.u.) and 1300 (300 n.u.). Thus, the buy order for 755 n.u. is fully executed.
At the same time, limit buy orders at prices of 1200 and 1300 remain unfilled because the price slips through these levels. Those market participants who wanted to make a purchase at these prices are left either without a position or with partially filled orders.
Any price should be traded efficiently, having a balance between buys and sells, therefore, when inefficiency arises, the market will strive to cover these zones and return to balance. Everything in the world strives for balance, financial markets are no exception — this is due to the nature and psychology of market participants.
3. Fair Value Gap (FVG)
Fair Value Gap (FVG) is a graphical visualization of inefficient prices in the form of a three-candle formation, where the middle candle forms an imbalance.
FVG During an Uptrend
The zone is highlighted from the high of the candle before the impulsive candle to the low of the candle after the impulsive candle.
The bullish FVG is mainly formed only on an uptrend structure within an impulsive price movement.
Schematic example:
Example of Bullish FVGs During an Uptrend:
FVG During a Downtrend
The zone is highlighted from the low of the candle before the impulsive candle to the high of the candle after the impulsive candle.
The bearish FVG is mainly formed only on a downtrend structure within an impulsive price movement.
Schematic example
Example of Bearish FVGs During a Downtrend Structure:
4. Rebalance Process
As mentioned above, imbalances are mainly formed within impulses and most often behind the structural price movement. When a correction occurs, the price actively tries to balance itself, covering the imbalance zones (FVG). This process is commonly called rebalancing (rebalance).
During an uptrend, FVGs in Discount are considered the strongest zones.
During a downtrend, FVGs located in Premium are considered the strongest zones.
Schematic example:
FVG can be used in different contexts. For example, on higher timeframes, we will use it as a zone of interest for opening positions on lower timeframes. On lower timeframes, it will be used as an entry point for a position.
5. Types of Rebalance. Refill.
There are 3 types of imbalance zone (FVG) covering:
1. IOFED (Entry Drill) — partial covering of the FVG with a “spike” without reaching 50% of the zone. On a lower timeframe, we will see liquidity removal within the FVG.
2. 0.5 (50%) — covering 50% of the FVG. Usually, the price reacts specifically from this zone. A very important level during the FVG test, which allows you to most accurately determine the future price movement.
3. Full Fill — complete covering of the FVG. During a complete covering of the FVG, the probability of the price returning to the FVG zone is significantly reduced.
Repeated FVG Refills
The price can rebalance the FVG several times, until it completely passes through the entire zone with candle bodies. In simple terms, the FVG is valid and can give repeated reactions in the form of IOFED/0.5/Full Fill tests until the price completely breaks through it with a candle body.
Example of repeated rebalancing
In the chart example, we see how the price tests the FVG levels 5 times, and only on the 6th time does the price completely fix with candle bodies below this bullish FVG. During each of these tests, we could consider positions from these levels.
Context of Use
We cannot accurately predict which level the price will test, so FVG will be used more as a certain zone of interest, within which, on a lower timeframe, we will expect a break in the market structure as confirmation of the idea, and we will also understand whether there will be a reversal or the price will completely pass through the FVG without a reaction.
Fractality of FVG
There will often be times in the market when there are several FVG zones close to each other on the chart, and it will be quite difficult for us to determine which of these zones to use.
In this case, we just need to switch to a higher timeframe and find a whole FVG. We highlight it and use the 0.5 (50%) level as the strongest point for the next test.
Example: м15
On the M15 timeframe, we see an impulse, within which there are two main FVGs. How do we understand which of them is more likely to give a reaction?
Let’s move to the higher timeframe H1.
H1
On the H1 timeframe, we see one FVG, where the price reacts from the 50% zone. Therefore, we can say that one FVG on a higher timeframe looks like several FVGs on a lower one. Higher timeframe FVGs are stronger and more accurate than lower timeframe ones.
M15 — H1
Returning to M15, you can see that the upper M15 FVG intersects with the 0.5 level of the higher H1 FVG, therefore, it is from it that you should expect a reaction and consider entering a position. The lower M15 FVG is not tested.
6. Conclusion
All natural processes tend to be in equilibrium (balance), including markets, because they are built on the principles of mutual exchange and human psychology.
Imbalances are a very important part of the market, because they indicate a lack of balance, which most likely indicates the presence of large participants in the market.
FVG is a graphical representation of the zone of unfilled orders during an imbalance, which, in turn, subsequently force the price to stop or form a reversal.
We will use this tool in different contexts and formations, and we will return to it more than once in the following topics, where we will already consider FVG as a zone of interest and an entry point for a position.