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. Each peak of a regular head and shoulders pattern falls toward a support level, also known as a neckline, before it rises to create the next peak. A move below the neckline (in the case of a head and shoulders top) is used by traders as a signal of a reversal of the current uptrend.
BREAKING DOWN Neckline
The neckline is the part of the head and shoulders chart pattern that connects the two reaction lows to form an area of support or resistance. The head and shoulders chart pattern is commonly used to predict bullish or bearish reversals depending on whether it forms upward or in reverse (e.g. reverse head and shoulders, or head and shoulders bottom).
The neckline's slope can be drawn at a slight angle rather than horizontal, but it should remain more or less horizontal to be valid. Regardless of its slope, a move below the neckline of a regular head and shoulders pattern is always used as a signal of a downtrend. In the case of an inverse head and shoulders, the neckline is found as a level of resistance that has prevented the price from heading higher. A move beyond the neckline in this case would be used to signal the start of an uptrend.
Often times, the head and should pattern is used in conjunction with other forms of technical analysis that serve as confirmation, including other chart patterns or technical indicators. For example, traders may look at momentum indicators to see whether the neckline of a head and shoulders pattern will hold or whether there will be a reversal (e.g. making it a false breakdown or false breakout).
The following chart shows an example of a head and shoulders pattern neckline for Take-Two Interactive Software Inc. (NASDAQ: TTWO).
In the chart above, a head and shoulder chart pattern emerges between October 2017 and April 2018. The neckline is drawn between the two reaction lows formed throughout the pattern. After the breakdown occurs, the trendline serves as a key area of support and resistance on an ongoing basis, including when the stock broke back above those levels in May and rebounded from them in June. Traders may have also looked at momentum indicators or other factors to see if the neckline resistance would hold in May when the pattern turned out to be a false breakdown.
Chart courtesy of StockCharts.com.