What Is a Neckline?
The neckline is a level of support or resistance found on a head and shoulders pattern that is used by traders to determine strategic areas to place orders. A neckline connects the swing lows (which occur following the first two peaks) of the head and shoulders topping pattern. A move below the neckline signals a breakout of the pattern, and indicates that a reversal to the downside of the prior uptrend is underway.
In the case of a head and shoulders bottoming pattern, called an inverse head and shoulders, the neckline connects the two swing highs of the pattern and extends out to the right. When the price rises above the neckline it signals a breakout of the pattern and a reversal to the upside of the prior downtrend.
- The neckline connects the reaction lows of a head and shoulders pattern, or the reaction highs of an inverse head and shoulders pattern.
- The neckline is a straight line extended out to the right, and signals the breakout or completion of the pattern when the price drops (top) or rises (inverse) through it.
- A neckline that is severely sloped higher or lower isn't very useful for trading or analytical purposes.
What Does a Neckline Tell You?
The neckline is the part of the head and shoulders chart pattern that connects the two reaction lows (topping pattern) or highs (bottoming pattern) to form an area of support or resistance. The head and shoulders chart pattern is commonly used to predict bullish or bearish reversals.
When the price breaks below the neckline of a topping pattern it means the prior uptrend is likely over, and a downtrend is underway. When the price breaks above the neckline of an inverse pattern it means the prior downtrend is likely over, and an uptrend is underway.
The neckline's slope may sometimes need to be drawn at an angle, rather than horizontal. This is because the reaction lows or highs may not always be equal, and therefore, the line will take on a slope when connecting them. This is fine. If the neckline is severely sloped higher or lower, then it is less reliable for trading and analytical purposes.
The neckline is a straight line that connects the lows (top) or highs (inverse) and is extended out to the right. After the head and shoulders forms its third peak (top), if the price drops below the neckline, then the pattern is considered complete and a further downside move is expected.
Often, the head and shoulders pattern is used in conjunction with other forms of technical analysis that serve as confirmation, including other chart patterns or technical indicators. For example, if the relative strength index (RSI) or moving average convergence divergence (MACD) indicator was showing bearish divergence heading into the head and shoulders pattern, some traders would view that as added confirmation that the price is more likely to head lower after the downside neckline breakout.
Head and Shoulders Introduction
A head and shoulders forms after an uptrend and is composed of a peak, a retracement, a higher second peak, a retracement, a lower third peak, and a drop below the neckline.
Some traders enter short or exit long positions when the price drops below the neckline. For those entering short, a stop loss is often placed above a recent swing high or above the high of the third peak.
The estimated downside move for the head and shoulders is the height of the pattern—which is the difference between the prices of the second peak to the lowest low of the two retracements—subtracted from the neckline breakout point. This is called the price target. There are no guarantees the price will reach that level, or that it will stop falling at that level. It is just an estimate.
The same concepts apply to an inverse head and shoulders, except everything is flipped upside down. The pattern forms after a downtrend and is composed of a low, a move higher, a lower low, a move up, a third higher low, and then a rally above the neckline.
Some traders enter long positions or exit short positions when the price rises above the neckline. For those entering longs, a stop loss is often placed below a recent swing low or below the low of the third low.
The height of the pattern is added to the neckline breakout point to provide an upside target.
Example of How to Use a Neckline
A head and shoulders pattern formed in the GBP/USD, which is the currency exchange rate between the British pound and the U.S. dollar.
The head and shoulders is formed by a first peak, a second higher peak, and then a third lower peak, with retracements in between. The neckline connects the lows of the retracements and is extended out to the right.
Following the third peak, the price breaks below the neckline signaling further downside may be likely. The height of the pattern is subtracted from the neckline breakout point to provide an estimated price target for the move down.