What is a neckline?
The neckline is a level of support or resistance found on a head and shoulder pattern that is used by traders to determine strategic areas for placing orders. A neckline connects the swing bottoms (which occur after the first two peaks) of the head and shoulders. A movement below the neck signals a break in the pattern and indicates that a downward reversal from the previous uptrend is in progress.
In the case of a head and shoulder bottom motif, called an inverted head and shoulders, the neckline connects the two oscillating vertices of the motif and extends to the right. When the price rises above the neckline, it signals a break in the pattern and an upside reversal from the previous bearish trend.
Key points to remember
- The neckline connects the reaction hollows with a head and shoulders motif, or the reaction tops with an inverted head and shoulders motif.
- The neckline is a straight line extended to the right and signals the bursting or completion of the pattern when the price drops (up) or increases (reverse) through it.
- A neckline that is strongly tilted up or down is not very useful for commercial or analytical purposes.
What does a neckline tell you?
The neckline is the part of the graphic pattern of the head and shoulders that connects the two reaction hollows (vertex pattern) or the tops (hollow pattern) to form a support or resistance area. The head and shoulder chart model is commonly used to predict bullish or bearish reversals.
When the price falls below the neck of a top model, it means that the previous upward trend is probably over and a downward trend is underway. When the price exceeds the neckline of an inverse model, it means that the previous downward trend is probably over and an upward trend is underway.
The slope of the neckline may sometimes need to be drawn at an angle rather than horizontal. Indeed, the ups or downs of the reaction may not always be equal and, therefore, the line will slope when connecting. Its good. If the neckline is severely in a higher or lower slope, it is then less reliable for commercial and analytical purposes.
The neckline is a straight line that connects the bottom (top) or the top (reverse) and extends to the right. After the head and shoulders form its third peak (top), if the price drops below the neckline, the model is considered complete and another downward movement is expected.
Often the head and shoulders model is used in conjunction with other forms of technical analysis that serve as confirmation, including other models of charts or technical indicators. For example, if the relative strength index (RSI) or the moving average convergence divergence indicator (MACD) showed a bearish divergence in the head and shoulders model, some traders would consider that as additional confirmation that the price is more likely to fall after the bearish neckline breaks.
Introduction to the head and shoulders
A head and shoulders form after an uptrend and are composed of a peak, a retracement, a second higher peak, a retracement, a third lower peak and a fall below the neckline.
Some traders take short positions or exit when the price falls below the neckline. For those entering the short, a stop loss is often placed above a recent high swing or above the high of the third peak.
The estimated downward movement for the head and shoulders is the height of the pattern – which is the difference between the prices of the second peak and the lowest of the two retracements – subtracted from the break point of the neckline. This is called the price target. There is no guarantee that the price will reach this level or that it will stop falling at this level. This is only an estimate.
The same concepts apply to an inverted head and shoulders, except that everything is inverted. The pattern forms after a downward trend and consists of a bottom, a higher movement, a lower bottom, an upward movement, a third lower, then a rally above the neckline.
Some traders take long positions or exit short positions when the price rises above the neckline. For those entering the long, a stop loss is often placed below a recent swing bottom or below the lowest of the third lowest.
The height of the pattern is added to the break point of the neckline to provide an upside-down target.
Example of using a neckline
A pattern of head and shoulders has formed in GBP / USD, which is the exchange rate between the British pound and the US dollar.
The head and shoulders are formed by a first peak, a second upper peak, then a third lower peak, with intermediate retracements. The neckline connects the bottom of the retracements and extends to the right.
After the third peak, price drops below the neck signaling a further decline may be likely. The height of the pattern is subtracted from the break point of the neckline to provide an estimated price target for the drop.