Overview and examples in Technical Analysis

What is a neckline?

The neckline is a level of support or resistance found on a head and shoulders pattern used by traders to determine strategic areas to place orders. A neckline connects the swing lows (occurring after the first two peaks) of the head and shoulders top pattern. A move below the neckline indicates a breakout of the pattern and indicates that a reversal to the downside of the previous uptrend is underway.

In the case of a head and shoulders bottom pattern, called an inverted head and shoulders, the neckline connects the two swing highs of the pattern and extends to the right. When the price rises above the neckline, it indicates a breakout of the pattern and a reversal to the upside of the previous downtrend.

What does a neckline say to you?

The neckline is the part of the head and shoulders chart pattern that connects the two reaction lows (top pattern) or highs (bottom 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 an upside pattern, it means that the previous uptrend is likely over, and a downtrend is underway. When the price breaks above the neckline of a reversal pattern, it means that the previous downtrend is likely over, and an uptrend is underway.

The neckline is a straight line that connects the lows (top) or highs (reversed) and is extended to the right. After the head and shoulders form their third peak (above), if the price drops below the neckline, the pattern is considered complete and a further downward move is expected.

The slope of the neckline should sometimes be drawn at an angle, rather than horizontally. This is because the response lows or highs may not always be equal, and therefore the line will assume a slope when they are connected. If the neckline is severely skewed higher or lower, then it is less useful for trading and analytical purposes.

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 shows bearish divergence on the way to the head and shoulders pattern, some traders will take this as additional confirmation that the price is more likely to be lower after the downward neckline breakout.

Head and shoulders pattern

A head and shoulders pattern forms after an uptrend and consists 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 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 from 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 that the price will reach that level, or that it will stop falling at that level. This is just an estimate.

The same concepts apply to an inverted head and shoulders, except in reverse. The pattern forms after a downtrend and consists 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 longing, a stop loss is often placed below a recent swing low or below the low of the third low.

Example of how to use a neckline

A head and shoulders pattern is forming in the GBP/USD, which is the exchange rate between the British pound and the US dollar.

The head and shoulders pattern 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 to the right.

After the third peak, the price breaks below the neckline indicating further downside may be likely. The height of the pattern is subtracted from the neckline breakout to provide an estimated price target for the move down.

Investopedia does not provide tax, investment or financial services and advice. The information is presented without regard to the investment objectives, risk tolerance or financial circumstances of any particular investor and may not be suitable for all investors. Investing involves risk, including the possible loss of principal.