There are basically three different basic approaches to analyze stock prices, either with fundamental analysis, technical analysis or with statistical tools.
The most common way to analyze shares is through fundamental analysis which is based on using fundamental data such as facts about the financial state of the company and its markets to make an estimation of future profits. Fundamental traders then can evaluate if a share is over- or undervalued. Unfortunately, traditional fundamental analysis is not enough to explain all movements of the stock market. For instance, it is difficult to explain the relatively large price motions of most stocks with traditional fundamental analysis.
People advocating technical analysis hold that all factors influencing price that fundamental traders are using already is reflected in stock prices and that fundamental analysis therefore is not effective. Fundamental economic estimations of growth and profit margin are moreover far too uncertain. It is people that are buying and selling, and that is why the price will reflect human psyche, at least in the short run.
Technical Analysis is an approach that uses information of past stock behavior in order to forecast future price movements. Within the technical analysis community, there exists several schools with different techniques, but they all have in common that they use price and volume history. A basic thought is that it takes time before the market reacts upon new information and that pattern often occur in price behavior which makes forecasting possible.
A third approach based on statistics is more evidence-oriented. One goal is not to find patterns within price history for a certain stock, but to find patterns valid across all stocks. The price development of a certain stock is analyzed and compared to a large dataset of results for stocks with similar price development. If there exists a correlation to future returns for stocks exhibiting similar price patterns, you can use this correlation when trading.
One advantage is that you are not optimizing within historical prices of a certain stock, but checking price patterns of the stock to a dataset providing estimations of future returns, and other measures. You are thus eliminating curve-fitting and gaining statistically valid estimations.
Optimal Trader is a tool combining technical analysis with statistical approaches and data mining (the process of extracting hidden patterns from data) giving you the advantages of both means.
There are traders skeptical to technical analysis and it should be pointed out that the efficient market hypothesis implies that if the market is efficient, there is no way of making any forecasts of future prices with the help of technical analysis.
The stock market is not an efficient market. Herding behavior is common among investors, all investors are not getting all information at the same time and the time it takes to evaluate information before they act differs between investors. Many investors are not showing rational behavior. Greed and fear are strong feelings and may result in panic sales and stock market bubbles.
In summary, there are several factors that explain why technical analysis works:
There exist several academic studies which show that technical analysis does work.
<<< Collection of academic studies about Technical Analysis >>>
Lagging indicators help you decide when shares are in a stable advancing phase (positive trend). The central assumption for a following indicator is that a share that has ascended during a period will continue to ascend with larger probability than turning downward. That this is the case is easy to see in many price charts, where it is easy to find trends. (It is always easy when looking on historical price movements)
Leading indicators, on the other hand, origin from the assumption that every trend sooner or later will be broken.
The biggest advantage with leading indicators is early signaling for entry and exit points. Leading indicators generate more signals and allow more opportunities to trade. Early signals can also help to forewarn against potential strength or weakness.
The disadvantage with leading indicators is that they generate more false signals. False signals increases losses and can generate commissions that eat away your profits.
Statistical indicators are not optimizing model parameters for historical prices of the stock, but instead finding patterns in the price motions of the stock, and checking against a large dataset whether these patterns have any indication for future returns. Optimal Trader has one pure statistical indicator, the Statistical Classification Indicator, and a globally pre-trained artificial neural network. Both of these indicators are not optimizing parameters on historical prices of the current stock. Instead their behaviour is based on globally valid indications for future returns based on the current price pattern of the stock.
If you are interested there is a lot to read about technical analysis on the Internet, and we recommend you to learn more and experiment before trading seriously following a trading system. We are convinced that technical analysis provides the means of making good profit when investing your capital.
To read more about how psychological factors influence advances and declines on the stock market we really recommend the book Trading With Crowd Psychology by Carl Gyllenram.