What Is a Neckline?

What Is a Neckline?

Let me explain what a neckline is in technical analysis. It's a level of support or resistance that you find on a head and shoulders pattern, and traders like you use it to figure out strategic spots for placing orders. In a head and shoulders topping pattern, the neckline connects the swing lows that follow the first two peaks. If the price moves below this neckline, it signals a breakout and means a reversal to the downside of the previous uptrend is starting.

For the inverse head and shoulders, which is a bottoming pattern, the neckline connects the two swing highs and extends to the right. When the price rises above it, that signals a breakout and a reversal to the upside from the prior downtrend.

Key Takeaways

Here's what you need to remember about necklines. They connect the reaction lows in a head and shoulders pattern or the reaction highs in an inverse one. You can use them to predict when an asset's price has hit a top or bottom. The neckline is a straight line extended to the right, and it signals the pattern's completion when the price breaks through it—dropping for a top or rising for an inverse. If the neckline is severely sloped up or down, it's not very useful for your trading or analysis.

What Does a Neckline Tell You?

The neckline is that part of the head and shoulders chart pattern connecting the two reaction lows in a topping pattern or highs in a bottoming one, creating an area of support or resistance. You know the head and shoulders pattern is popular for predicting bullish or bearish reversals.

If the price breaks below the neckline in a topping pattern, it tells you the uptrend is probably over and a downtrend is beginning. Conversely, breaking above in an inverse pattern means the downtrend is likely ending, and an uptrend is starting.

You draw the neckline as a straight line connecting those lows or highs and extend it rightward. After the third peak in a topping pattern, if the price drops below the neckline, the pattern is complete, and you can expect further downside.

Sometimes you might need to draw the neckline at an angle because the reaction points aren't equal, giving it a slope. But if it's severely sloped, it's less useful for trading. Often, you'll combine this with other technical analysis for confirmation, like RSI or MACD showing bearish divergence before a head and shoulders, which adds weight to expecting a drop after breakout.

Head and Shoulders Pattern

A head and shoulders pattern forms after an uptrend, with a peak, retracement, higher second peak, another retracement, lower third peak, and then a drop below the neckline. You might enter short or exit longs when the price drops below the neckline, placing a stop loss above a recent swing high or the third peak's high.

To estimate the downside, subtract the pattern's height—the difference from the second peak to the lowest retracement low—from the neckline breakout point. That's your price target, but remember, it's just an estimate; no guarantees on reaching or stopping there.

The inverse head and shoulders works in reverse, forming after a downtrend with a low, move up, lower low, move up, third higher low, and rally above the neckline. You could enter longs or exit shorts on the rise above the neckline, with a stop loss below a recent swing low or the third low.

For the inverse, add the pattern height to the breakout point for an upside target.

Example of How to Use a Neckline

Take the GBP/USD exchange rate as an example. A head and shoulders pattern forms with a first peak, higher second peak, third lower peak, and retracements in between. You connect the retracement lows to form the neckline and extend it right.

After the third peak, the price breaks below the neckline, signaling potential further downside. Subtract the pattern height from the breakout point to get your estimated downside target.

Common Questions About Head and Shoulders Patterns

You determine a head and shoulders stock pattern if prices fall below the neckline after the third peak, confirming a reversal and predicting further declines.

On a stock chart, it looks like three consecutive peaks, with the middle one highest, and the neckline connecting the two troughs. Confirmation comes when prices fall below it after the third top.

With a head and shoulders in technical analysis, it's a bearish sign, so the asset might keep losing value, but it's not foolproof—check other factors for confirmation.

After the pattern, stock prices generally fall, but verify with volume, relative strength, and other metrics.

For trading an inverse head and shoulders, which is bullish, go long after confirmation, expecting new highs.

Disclaimer

This information is for educational purposes only. It doesn't consider your specific investment objectives, risk tolerance, or financial situation, and it might not suit all investors. Investing carries risks, including possible loss of principal.