The Significance of Necklines in Technical Analysis

Summary

Necklines play a pivotal role in technical analysis, aiding traders in understanding potential trend reversals and guiding their entry and exit points in the market. This blog aims to help you understand the intricacies of necklines so that you may effectively use them while trading.

If you want to be better at recognising chart patterns, pinpointing possible breakout spots, and setting up well-thought-out entry and exit strategies, then you’ve come to the right place. 

In this article, we shall take a look at the characteristics of the neckline and understand its applications. So, if you’re ready to crack the code and successfully navigate the financial market, read on. 

What is a neckline?

While looking at a price chart, you would notice a line connecting a series of price points. These are called trendlines. In the case of the head and shoulder, inverse head and shoulder, double top, and double bottom patterns, we call this trendline the “neckline.”

The neckline is an important element in technical analysis as it will help you identify strategic buying opportunities.

How is that you ask?

That’s because a neckline denotes the level of resistance, and a break of the neckline often signals a substantial change in the demand and supply of an asset and signals the beginning of a new trend. You can use this to predict prices and trade accordingly.

Another reason why the neckline is important is because a pattern can be considered closed only after the price breaks above or below it. 

Now that you know the significance of understanding the neckline, let’s look at examples of the head and shoulders and inverse head and shoulders patterns to understand what the neckline indicates in each case and how to interpret the chart using them. 

Interpreting the neckline in a head and shoulders pattern

In a head and shoulders pattern the neckline connects the two lowest points that are formed – like the troughs of a “W”. When the breakpoint is below the neckline, it signifies the end of a bullish trend and signals that a bearish trend is underway. The neckline is not always a straight horizontal line. It may sometimes slant upward or downward.

Taking the example of XYZ Inc. Stocks above, the neckline can be seen connecting the two lowest points. From this, you can make the following interpretation: 

• The price declines below the neckline after the right shoulder which means a reversal pattern and the prices will continue downward.
• Only when the price breaks through the neckline and closes below it can the pattern be confirmed and be considered safe to trade.
• The fluctuation of volume from high to low and high again as the price advances from the left shoulder, head and right shoulder should be considered as a warning.
• Another warning is when the volume decreases while declining from the head which is then followed by an increase in volume during the decline in the right shoulder.

Importance of the neckline in setting the price target in a head and shoulders pattern 

• Entry point - Trade only when the price breaks below the neckline, preferably one that is accompanied by a substantial trading volume.

• To calculate the potential price - you must measure the distance between the tip of the head and the neckline.
• To calculate the potential downside target price – you have to measure the distance from the breakout point which is where the neckline meets the outer side of the right shoulder. 

Interpreting the neckline in an inverse head and shoulders pattern

An inverse head and shoulders pattern is the opposite of the head and shoulders pattern where the neckline connects the two highest points of the stock price. It indicates a bullish trend – a reversal from a downward trend to an upward trend.

As you can see from the image above, unlike the head and shoulders pattern this one has three troughs. If the price increases after breaking the neckline post the third trough, you can interpret this as a reversal of the downward trend and that the price of the stock might continue to increase.

Importance of the neckline in setting the price target in an inverse head and shoulders pattern

• Entry point - Trade only when the price breaks above the neckline, preferably one that is accompanied by a substantial trading volume.

• To calculate the potential price - you must measure the distance from the tip of the head to the neckline.
• To calculate the potential upside target price – you have to measure the distance from the breakout point which is where the neckline meets the outer side of the right shoulder. 

To sum it all up

Necklines are tradelines that are found in patterns such as head and shoulders, inverse head and shoulders, double top, and double bottom patterns. Note that a pattern can be considered closed only after the price breaks above or below it. The neckline is an important element in technical analysis as it helps analysts as well as investors to identify strategic buying opportunities. By analysing Necklines, you can determine entry, target price, and place stop-loss orders to mitigate risks.