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Mock Exam
C

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Level 3 Mock Exam — Questions
Question #1: Ethics (12 Points)
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1A. Victor Valezia, CMT, is a technical analyst who publishes technical opinions for an investment
bank. His good friend Jarom works as a midlevel production manager for WEI Industries, a large
manufacturing company. At lunch Jarom explained to Victor than his company had to fill a very
large order for their customer, Super Motors Inc. (SPMI). Jarom felt certain that his company
would be late with their shipments and expressed his opinion that this would in turn hurt SPMI
sales and revenues in the upcoming quarter.
Victor returned to his office and checked the chart of SPMI to see if it showed any technical
weakness. He found that there were a number of major weaknesses and he published a
recommendation based solely on technical factors that SPMI was a near-term sell.
Based on this information, which of the following statements is most accurate? (2 points)
A. Victor committed no violation.
B. Victor violated Ethics Standard 1 regarding professional competence, integrity, and judgment.
C. Victor violated Ethics Standard 2, making technical recommendations which were inaccurate
or misleading.
D. Victor violated Ethics Standard 5 regarding acting on inside information.
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1B. Chris Cox, CMT, was a portfolio manager for a large hedge fund and left to start her own fund.
One of her first actions was to announce to everyone on LinkedIn that she had made the change.
Many of her connections on these systems were made through associations with her former
employer and those people are still clients.
A. Chris committed no violation.
B. Chris has violated Ethics Standard 1 by behaving unprofessionally.
C. Chris has violated Ethics Standard 6 by contacting clients from her previous employer.
D. Chris has violated Ethics Standard 7 by not keeping client matters private.

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1C. James Overtone, CMT, is a high-profile technical analyst who is a favorite on several financial
television shows. His assistant analyst told him that their recent research results showed a
30 percent chance that markets could close significantly higher. He had no time to check the
research for himself because later that day he had a television interview. On air he answered a
brief question about his market forecast with these words: “I am certain that we are not about to
enter a bear market any time soon as some other analysts have said. My research shows about a
90 percent chance that markets will rise over 23 percent by the end of the year.”
A. James has violated Ethics Standard 4 by disparaging and discrediting the analytical work of
others.
B. James has violated Ethics Standard 9 by not mentioning that he is a CMT.
C. James has violated Ethics Standard 5 regarding insider trading.
D. James has violated Ethics Standard 2, making technical recommendations which were
inaccurate or misleading.
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1D. Ginger Rojas, CMT, is the chief strategist for a hedge fund. Her research department
recommended making a large investment in a particular company. Before giving the research to
her portfolio manager, she decided to put some of her own money in the investment, so she went
and purchased those same shares in her own account.
A. Ginger committed no violation.
B. Ginger has violated Ethics Standard 2, making technical recommendations which were
inaccurate or misleading.
C. Ginger has violated Ethics Standard 7 regarding giving a client adequate opportunity to act
on a recommendation before doing so themselves.
D. Ginger has violated Ethics Standard 8 by not giving adequate credit for the research work of
others.

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1E. Marie Alai, CMT, has worked as a research assistant for several years, and has just been
promoted to analyst. While working as an assistant she found that she could use momentum
and linear regression to identify potential turning points in stocks. She kept the details of this
personal method a secret, and so far has a great track record using it to make her calls. When the
marketing department of her firm asked her how she arrived at the conclusion, she simply told
them it was proprietary in order to get them to leave her alone. But the marketing group dressed
up her statement, and sent it out in a research report titled “Proprietary Indicator Signals ABC
Stock Will Rise 30%.”
A. Marie is in violation of Ethics Standard 1 because she is not sharing information with those
who want it.
B. Marie committed no violation.
C. Marie is in violation of Ethics Standard 2 by making recommendations that fall outside
generally acceptable research.
D. Marie is in violation of Ethics Standard 3 because she is using undisciplined technical
analysis without a documented process while leading others to believe that her technically
derived views of future security price behavior reflect a prediction akin to foreknowledge
rather than estimates.
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1F. Bill Ratliffe, CMT, researched a buy recommendation on stock ABCX. Over the weekend he told
family members that he would publish it in his next newsletter, and he also bought shares in his
wife’s account. He published his recommendation the next week.
A. Bill committed no violation.
B. Bill has violated Ethics Standard 3 by fully documenting his procedures and rationale in
making his forecast.
C. Bill has violated Ethics Standard 2 by leading others to believe that his technically derived
views of the market are based on foreknowledge rather than estimates and projections.
D. Bill has violated Ethics Standard 7 by not giving customers adequate time to purchase the
stock before acting on behalf of others.

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Question #2: Behavioral Finance (20 points)
Note: The following question has much more explanation than would be necessary to answer the
question. The additional explanation is added here for the convenience of those studying the sample
exam. One to three sentences would suffice for the answers that follow.
(1 point) Answer should include a mention of one of the following points as the solution:
Use the following information to answer questions 2A through 2C.
In the book Behavioral Investing, author James Montier played a game with his clients, investing
professionals, to test their strategic thinking. The game included choosing a number between 0 and 100
that will be 2/3 as much as the average of all numbers chosen by game participants.
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2A. Summarize what kind of approach Montier suggested a participant might be able to use to come
closest to a winning answer. (2 points)
Explain how such a strategy applies generally to investing decisions. (3 points)
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2B. Identify which five of the following are phases of an asset bubble as Montier describes
them: (5 points, 1 point each)
A. Lethargy—markets going nowhere.
B. Displacement—exogenous shock triggers profit opportunity in some sectors but not in others.
C. Credit creation—boom and monetary expansion.
D. Debt consolidation—consumer confidence dissipates.
E. Euphoria—overestimate of returns.
F. Critical stage—financial distress as insiders cash out and firms consider defaulting.
G. Revulsion—investors stop participating, paralyzed by fear.
H. Capitalization—traders take advantage of market moves.
I. Recovery—markets begin to rebound.
J. Transition—capital markets become more liquid.

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2C. Suppose a hedge fund recently acquired a large position of stock in company XYZ. The fund’s
analysts have come to believe that XYZ is in its own asset bubble. They have just reported that
their new research into the company now leads them to conclude that XYZ will unavoidably face
some form of default within the next year. XYZ stock has risen over the past year and the P/E
ratio has nearly doubled in that time. During the most recent two months price action has begun
to flatten out and volatility is starting to increase. There are rumors that a board member has been
aggressively selling shares. The portfolio manager wants to hold on a bit longer so the fund can
sell the shares at a price just a bit higher than for which it was acquired. (10 points)
Explain the following three things:
1. What bias the portfolio manager is showing
2. Which of Montier’s phases of an asset bubble may be suggested by the price action
3. An application of Kahneman’s loss-aversion theory and how this concept is influencing
the portfolio manager

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Question #3: Intermarket Analysis (25 points)
Use the following information to answer questions 3A through 3E.
You are a large-cap portfolio manager. Despite your large-cap mandate, you like to monitor the relative
strength ratio of the small-cap stock index divided by the large-cap stock. After a nine-month downtrend
this relative strength ratio has put in a bottom and has started to move higher.
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3A. What sector should you consider adding exposure to? (3 points)
A. Consumer Staples
B. Technology
C. Healthcare
D. Utilities
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3B. Give two reasons why small-cap relative strength suggests you should add to this
sector? (6 points)
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3C. Copper has been selling off for the past month on an absolute basis and relative to other
currencies. As an emerging markets equity manager, which country should you consider reducing
exposure in? (3 points)
A. China
B. India
C. Mexico
D. Russia
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3D. Explain one reason why weakness in copper would cause you to consider reducing exposure to
this country. (5 points)
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3E. The correlation between stock prices and bond yields was negative from 1967 to 1997. However,
after 1997 the correlation turned positive. Name the macroeconomic force(s) that led to the
change in correlation in 1997. (8 points)
4 points awarded for an answer that references the effects of deflation in the correlation. Full
8 points for an explanation of the changing signal that rising yields provided stock investors
during a deflationary environment.

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Question #4: Risk Management (38 points)
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4A. Risk control can involve complex mathematics, but there are a number of commonsense
principles the investment professional can follow to reduce the risk of ruin. List three of the most
important commonsense risk-control rules according to Kaufman. (12 points)
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4B. You work for a CTA firm and have worked hard to develop several viable trading systems
covering a diversified variety of market instruments. You have taken care to properly test these
systems, avoiding data snooping or curve-fitting them to in-sample data. Next, you merged these
several systems into an overall portfolio model.
According to Kirkpatrick and Dahlquist, what would be the next testing method you would
choose to determine the probability of your trading system succeeding, given a wide variety of
possible market scenarios going forward? (6 points)
Briefly describe that testing method and its meaning.
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4C. Your latest system is a trend-following system and the market conditions were favorable for
trend-following during the last year. The general partner of your CTA firm wants to put your
system in place this year, but before doing so he wants you to explain what could go wrong.
Which of the following would you say is the main disadvantage of a trend-following
system? (4 points)
A. Pyramiding position size, as the trend continues, increases risk.
B. Position size has to be maintained in both trending and trendless market environments.
C. As the trend advances, risk increases and the advantage of the fat tail declines.
D. In a trendless market a series of small losses can occur which can add up to a large
drawdown.
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4D. List three steps that, when added to a trading plan, would limit the major disadvantage of a
simple trend-following system. (9 points total, 3 per step)

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4E. The general partner of your hedge fund tells you that he would like to use the Calmar ratio as a
measure of performance for your system. Explain what this ratio is and give one reason why the
general partner’s choice is, or is not, likely to be a useful measure of your system’s performance
as a part of delivering value to the firm’s clients. (7 points)

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Question #5: Strategies and Techniques (30 points)
Use Chart 5-1 to answer question 5A.
Chart 5-1
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5A. You are newly hired into XRHO Capital Management, a CTA firm. Last year the firm took a long
position in coffee futures (KC). The position is profitable and has met its objectives, and you are
tasked with recommending whether the current conditions suggest it would be most favorable to
sell now or to wait. Select either decision but explain at least four points of evidence to correctly
support your decision from among the applicable signals on Chart 5-1. (12 points)

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Use Chart 5-2 to answer questions 5B and 5C.
Chart 5-2
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5B. Your predecessor recommended the firm initiate a short position on MMM, but failed to leave any
explanation for this chart. Describe the three signals the analyst likely observed using available
detail on Chart 5-2. (15 points)
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5C. Your predecessor recommended the firm enter the short position at $125 and set a stop-
loss at $130. If the firm had a fund of $5 million and wanted to take the trade and put only
1.5% of that amount at risk, how many shares could be traded (assuming no loss to gaps or
slippage)? (3 points)

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Question #6: Asset Relationships (40 Points)
Use Chart 6-1 to answer questions 6A through 6D.
Chart 6-1
Chart 6-1 shows a comparison between GLD and XAU. Here GLD is being used as a proxy for gold
prices. This chart attempts to visually identify two-week periods where the relationship between these
two entities forecasts the behavior of GLD prices over the subsequent four weeks.
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6A. Katsanos noted a short-term relationship between the XAU index and gold prices in which he
stated that XAU was a ____________ (leading/lagging) indicator compared to gold. (5 points)
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6B. Which of the two sets of indicator areas (marked by gray-shaded or blue-shaded columns)
confirms the choice you made in 6A? (10 points)
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6C. Describe whether these areas confirm your understanding of Katsanos’s observations about
whether XAU leads gold or gold leads XAU. (10 points)
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6D. Describe the qualifications and limitations a responsible technical analyst should consider when
making a visual observation such as the one in Chart 6-1. (15 points)

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Question #7: Candlestick Analysis (40 Points)
Use Chart 7-1 to answer questions 7A through 7C.
Chart 7-1: GDX
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7A. You are a recently hired analyst. Your portfolio manager wants your short-term recommendation
on GDX, a gold-mining ETF. You must make the best recommendation on whether it be a LONG
or SHORT position, and you must provide evidence to support your conclusion. Examine
Chart 7-1: GDX. Do you recommend a LONG or SHORT position in this security? (1 point)
Name and discuss the implication of the two most recent multi-day candlestick patterns that
support your conclusion. For each candle, comment if there is anything significant in the chart
that increases the strength of each candle pattern? (6 points)
Note to students: You may see that a harami is present on Oct. 15. However, a bullish harami
reversal needs to have a solid black candle followed by a smaller candle (the second candle can be
white or black).
Also, since this question is asking for a multi-day candle pattern, a reference to a window would not
be accepted.
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7B. In Chart 7-1 how do the indicators Williams %R and ATR factor into your analysis? (5 points)

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7C. Determine how many shares can be traded (long or short), rounded to the nearest 100 shares.
Use Chart 7-1 and assume the following conditions and demonstrate how you arrived at your
answer: (4 points)
• Trade entry price of $24.50 (long or short).
• Position risk limited to $15,000.
• Use ATR to calculate your stop price. Assume the last ATR reading is .86. Use a factor of
1.5 in your ATR stop calculation.
Use Chart 7-2 to answer questions 7D through 7H.
Chart 7-2
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7D. Examine the four labeled circles in Chart 7-2. In each circle there is a multi-day candlestick
pattern. Which circle contains a candlestick pattern that did not perform in line with its standard
forecast? (2 points)
A. Circle 1
B. Circle 2
C. Circle 3
D. Circle 4

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7E. What name would you give to the pattern you selected in question 7D? (2 points)
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7F. Which one of the following candlestick patterns would be most significant as evidence of a
continuation in the current trend, if it occurred next on Chart 7-2? (2 points)
A. Falling three methods
B. Upward gapping tazuki
C. Upside gap, two crows
D. Low-price gapping play
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7G. Of the following choices, which one of these patterns would be more significant as a reversal
indicator, if it occurred next on Chart 7-2? (2 points)
A. Umbrella line
B. Southern doji
C. Bearish separating lines
D. Down gap, side-by-side white lines
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7H. Having examined the fundamentals of the security in Chart 7-2, a research firm just released an
official “sell” recommendation on it today. Comment on whether the provided indicators, MACD
and the Money Flow Index, are “overbought” at their current levels. In your opinion, do these
indicators support the firm’s conclusion to “sell” the stock today? In your answer, provide a brief
definition of how each indicator works. (11 points)

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Use Chart 7-3 to answer question 7I.
Chart 7-3
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7I. Examine Chart 7-3 (10-Year U.S. Treasury Prices). Which circle contains the candle (1, 2, 3, or
4) that was most significant in forecasting a break above the resistance line? Why? What is your
short-term forecast for U.S. Treasury bond prices based on this chart? (5 points)

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Question #8: System Development (35 Points)
Use the following information to answer questions 8A through 8F.
All technical analysis–based trading systems have a random component as well as a predictive
component. In order to make a trading system as robust as possible, we must reduce the random
component where possible during the backtest development phase, or what Aronson calls the data mining
bias. He defines the data mining bias as the expected difference between the returns observed during the
data mining phase (backtesting) and its true expected performance trading live in the future (Aronson,
Chapter 6).
Aronson defines five factors that determine the magnitude of the data mining bias. Answer the following
questions regarding each of them.
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8A. The number of rules back tested. As the number of rules increases, does the data mining bias
increase or decrease? Explain one reason why. (10 points)
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8B.
The number of observations (the number of trades in the back test) used to compute the
performance statistics. Does more observations (trades) increase the bias or decrease the bias?
Explain one reason why. (5 points)
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8C.
Correlation among rule returns. Will five uncorrelated rules increase or decrease the bias when
compared to five highly correlated rules? Explain one reason why. (5 points)
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8D. Percentage of positive outlier returns. Will return samples with fat tails comprised of several
extreme values increase or decrease the data mining bias? Explain one reason why. (5 points)
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8E.
Variation in expected returns among the various rules. If the variation in return among
the expected rules is low, is the data mining bias lower or higher? Explain one reason
why. (5 points)
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8F. Which of the five factors is the most important in reducing the data mining bias
(randomness)? (5 points)

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Level 3 Mock Exam — Solutions
Question #1: Ethics
1A. Answer: D
1B.
Answer: A
1C.
Answer: D
1D. Answer: C
1E.
Answer: D
1F.
Answer: D

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Question #2: Behavioral Finance
2A. Answer:
The game is to choose a number between 0 and 100. The winner is the answer that is two-thirds
the average of all answers given.
• The game is simple under standard assumptions of economics (i.e., rationality and
common knowledge). Since all players know they need to choose 2/3 the average, the
only answer is zero: X = 2/3 × X.
• The game can be solved by iterated dominance. Choosing a number higher than 67 is a
dominated strategy because 67 is the highest number possible (if all others pick 100). But
knowing all others know what you know, they won’t “rationally” pick 100. So then the
highest outcome is really 2/3 of 67. And of course knowing that, you can iterate down
to zero, so the only logical answer is zero. But not everyone is rational. As soon as we
understand that not everyone is rational, the problem becomes more complex, just like
the market. As it relates to the markets, investors anticipate that others may sell (or buy)
before some sort of event and try to act before the herd.
• Rather than using iterated dominance, some simply selected 2/3 of the average of 0 and
100 or 33%, and some iterated to 2/3 of that, and so on. Eventually, enough iterations get
you to zero.
(1 point also awarded for a statement similar to one of these)
• This only works if assumption is that all participants are rational, which they are not.
• “Iterated dominance”: Knowing that if all choose 100, the maximum 2/3 is 67, leads one
to believe that 67 should be the maximum number. Eventually, 2/3 of all average numbers
eventually approach zero.
• Starting point should be 50, as in the average of 0–100. So 2/3 is 33…and so on until you
approach zero.
The contest provides a simple way of measuring the number of strategic steps of thinking the
players are doing. Most players use one, two, three, or infinite levels of thinking.
Many of the respondents suffered from the “curse of knowledge,” a false consensus effect. Ask
a group of smokers the percentage of the room that are smokers and they will guess a higher
number than asking the group of nonsmokers the same question. People believe that others think
the way they think. The players that picked zero tended to anchor their answers close to zero and
did not correctly estimate the degree of irrationality of the group as a whole.
Montier concludes in 2007 that the market was exhibiting a near-rational bubble driven by
increasingly short-time-horizon investors and overconfidence. Pressure on a month-by-month
basis to perform is driving professionals to a risky situation. However, not everyone is going
to get out at the top and inevitably many will be crushed under the exit stampede. According
to Montier’s results, most investors practice two steps of strategic thinking. Keynes notes that
investors are concerned with the third degree when we devote our intelligence to what the average
opinion expects the average opinion to be. If you are to beat the exodus, you need to be thinking

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in terms of three steps, but not more. That was represented by only 4% of the sample in Montier’s
game. He has a lot of skepticism over the ability of the majority of investors to “beat the gun.”
• Understanding that you must think ahead of the pack.
• Could also cite Keynes’s beauty-contest results where one must think what others are
thinking.
• Portfolio manager performance is directly related to their degrees of critical thinking.
This is directly linked to the CRT test where they scored poorly and they fell for all the tricks in
the questions; they tended to have an answer around 47, where, if they scored perfectly on the
CRT, they tended to answer 22 and demonstrated an ability to think ahead of the crowd.
2B.
Answer:
Displacement, credit creation, euphoria, critical stage (financial distress), revulsion
2C.
Answer:
(5 points) Loss aversion is our tendency to dislike losses far more than we like gains. In
numerous studies, we have seen that losses are valued at twice as much as gains. We learn that
everyone has a point of capitulation, but typically that is when the pain threshold is too high.
Montier calls this revulsion: Paralyzed with fear, investors can no longer participate. Capitulation
is generally used when a bull finally admits defeat. (In this example, the stock is still relatively
high and has not declined much yet.)
The status-quo bias and the endowment effect. Once you own something, you want to part with
it at a higher value than others would put on it. The default action is to do nothing. This also
leads to anchoring where investors like this hedge fund manager are anchored to the price they
bought it at, which is not the correct way of looking at the opportunity cost of still holding it.
Several biases are linked this way. Give maximum points if candidate appears to understand the
psychology of what is going on in the manager’s mind, and is not focused so much on what the
names of the biases are specifically. The key is that people have trouble taking a loss, they anchor
to irrelevant data points (like the level they bought a security), and so the default becomes doing
nothing until there is a “profit” (status quo).
(5 points) We are between euphoria and critical stage: Speculation for price (momentum) is
added to investment for production. Adam Smith referred to this as overtrading. Overestimate of
future returns or excessive gearing (we have seen this part, e.g., P/E has doubled).
Critical stage (financial distress): Insiders take profits and cash out. Significant insider selling
(we have not yet seen this part). Financial distress is when a firm contemplates not meeting its
liability obligations. As distress persists, perception of the crisis increases. Bank failures.

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Question #3: Intermarket Analysis
3A. Answer: B
3B.
Answer:
Small caps tend to lead large caps coming out of bear markets. (3 points)
Tech is typically an early cycle leader. (3 points)
3C.
Answer: A
3D. Answer:
China is the world’s largest producer and consumer of copper.
3E.
Answer:
Murphy argues that fear of deflation caused the correlation between stocks and bond yields
to turn positive. Traditionally rising yields were seen as a sign of an overheated economy and
stocks typically suffered as investors anticipated tightening from the Federal Reserve. However,
since 1997, rising yields have been a sign that deflation was less of a threat and stocks reacted
positively.
Murphy, pp. 129–145

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Question #4: Risk Management
4A. Answer:
(4 points each for any answer specified below)
1. Only risk a small amount of total capital on any one trade, no more than 5%.
2. Determine the maximum loss for the current trade in advance.
3. Exit a trade quickly.
4. Don’t meet margin calls.
5. Liquidate your worst position first when lightening up.
6. Be consistent in your trading philosophy.
7. Be sure the trading profile is compatible with your risk preference.
8. Plan for contingencies. Be prepared for exceptions.
Kaufman, p. 1032
4B.
Answer:
Monte Carlo simulation. (2 points)
It scrambles the PL trade data from a system from 100 to 2,000 times and generates an
equity curve for each simulation. If the great majority of the equity lines of these 100–2,000
simulations are without substantial drawdowns (beyond your acceptable threshold) and meet your
profitability requirements, then your portfolio system is probably robust. It is more likely to be
profitable and less likely to fail going forward. (4 points)
Kirkpatrick and Dahlquist (2011)
4C.
Answer: D

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4D. Answer:
1. We can reduce the size of our trades or stop trading trend-following systems completely
if we use one of a variety of methods designed to identify non-trending markets, such as
ADX. (3 points)
Kaufman, p. 1063
2. We can cut back on trading or stop trading trend-following systems completely when our
equity curve declines by a predefined amount. A standard for closing the entire portfolio
model is a percentage stop, usually around 20%. (3 points)
Kirkpatrick and Dahlquist (2011), p. 577
3. We can cut back on trading or stop trading trend-following systems completely when our
equity curve itself enters a quantified and predefined downtrend. (3 points)
Kaufman, p. 1032
4E. Answer:
Calmar ratio = CAGR / maximum drawdown over 3 years
The Calmar ratio is a useful measure of performance as a part of delivering value to the firm’s
clients.
The Calmar ratio is favored by hedge funds because it reflects gain-to-pain in the most realistic
way, with consideration given to time, the way (often impatient) investors look at it. (7 points)
Kaufman, pp. 1037, 1038

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Question #5: Strategies and Techniques
5A. Answer:
Acceptable explanations for sell now:
1. Falling wedge pattern failure. Coffee prices failed to meet the formulated price target
of $220 (from the $220–$160 range where $60 is height of the wedge). The high of the
trend from the subsequent pattern breakout was around $208. Bearish. (3 points)
2. The last day of coffee price action traded below the PSAR indicator, which is
bearish. (3 points)
3. The slow stochastic is still bearish from the last overbought reading above 80 when the
%K line crossed the %D line. (3 points)
4. Potential short-term double top. Coffee prices failed to rally above the recent high at
$208. Bearish. (3 points)
Acceptable explanations for hold (wait):
Recent coffee price action is converging at four major support levels:
1. At the lower Bollinger band level (3 points)
2. At the Fibonacci 38.2% retracement level (3 points)
3. At the MVWAP level (3 points)
4. At the $175 price, which is short-term price consolidation support between the recent two
highs (3 points)
5B.
Answer:
The three signals that are supportive of a short position are:
• Rising prices on declining trade volume divergence (5 points)
• Rising prices and declining RSI momentum divergence (5 points)
• Resistance shown at around 145 on the last 15 to 20 candles (5 points)
5C. Answer:
1.5% of $5 million is $75,000; therefore, in order to contain your risk of loss to that amount, the
position size in 3M (MMM) should be set at 15,000 shares sold short at the $125 price target
level.

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Question #6: Asset Relationships
6A. Answer:
Leading
6B.
Answer:
Should be gray-shaded if 6A was answered correctly, but if the answer above was selected as
“lagging,” then they should select blue-shaded for the correct answer here. Since the question is
about “which…confirms,” they must be consistent with their choice on 6A to get credit.
6C.
Answer:
This visual information confirms that XAU leads gold price at some points, but not always, which
is consistent with what Katsanos observed. Since XAU is being compared to GLD and not gold
spot prices, you could expect more inconsistency, so having three examples going both ways is
not unexpected in this graphic.
6D. Answer:
Katsanos said these were short-term correlations only. So while this is an interesting observation
and a nice, anecdotal confirmation, even if it were conclusive, it should only be discussed as a
short-term forecasting tool. However, this chart alone could not be used as a clear demonstration
of Katsanos’s observations. Further, it would be irresponsible to use this chart to conclude
a definitive forecast on gold prices while citing Katsanos, because this is not the exact same
relationship, and without a solid study (consistent with Aronson’s writings) on GLD versus XAU
price behavior, a technician should not use this to form the basis of a recommendation in the
short term.
Katsanos, Markos, Intermarket Trading Strategies, Chapter 7
Aronson, David R., Evidence-Based Technical Analysis, Chapters 5 and 6

27
Question #7: Candlestick Analysis
7A. Answer:
LONG.
• Separating lines is the most recent pattern. (1 point)
• This is a continuation pattern. (1 point)
• Given the fact a window occurred before it and price action has now crossed the moving
average line, this increases the strength of this bullish signal. (1 point)
• Bullish engulfing is the next most recent pattern occurring around October 15. (1 point)
• This is also a reversal pattern, occurring near the bottom. (1 point)
• The bullish engulfing candle engulfs two prior (small-body) candles, increasing its
significance. (1 point)
Nison, pp. 82–84
7B. Answer:
• Williams is a momentum oscillator, like RSI or stochastics, but its scale is inverted. It is at an
extreme overbought reading of 10 right now, and may be flattening out. (1 point)
• However, this extreme reading does not always mean “sell.” If this is the start of a new
trend, since price action is now above the moving average, a momentum oscillator can stay
overbought for a period of time as the trend continues. This occurred two prior times in the
chart. (2 points)
• ATR helps to measure volatility. Volatility has been declining as the security declined (in the
last downtrend). (2 points)
Note that there are two acceptable responses here: (1) Typically after a period of low volatility,
volatility tends to increase. Based on this chart, ATR is at its lowest range. Since the security just
broke above its moving average line, it is possible that we will see increased volatility (but not
confirmed yet). (2) ATR can be used as a breakout filter. If the breakout exceeds the ATR level, it
helps to confirm the breakout. In this case, the recent break above the moving average with the
gap is more than 86 cents, helping to add validity to the breakout.
Kirkpatrick, pp. 259–260
7C.
Answer:
1.5 times an ATR of 86 cents = $1.29. The stop would be placed $1.29 below the long entry price,
at $23.21. (2 points for correct discussion of stop price) Thus, rounding to the nearest hundred, a
total of 11,600 shares could be purchased at 24.50. (2 points for correct number of shares)
7D. Answer: D
Nison, p. 99

28
7E.
Answer:
Advance block
7F.
Answer: B
Nison, pp. 136–137
7G. Answer: A
Nison, pp. 32–33
7H. Answer:
• MACD cannot be “overbought” as it is not bound to a 0–100 scale, like a typical
oscillator. (2 points)
• It does not support the “sell” recommendation. (1 point)
• The 12- and 26-day moving averages continue to trend upward above the zero (signal) line,
with the faster average staying above the slower one. There are no immediate signs of those
two averages crossing, showing continued upward strength. (2 points)
• The Money Flow Index is considered “overbought,” as it is above 80. (2 points)
• This index is confined to a range between 0 and 100. However, despite its high levels, it does
not warrant an immediate “sell” recommendation. Oscillators can stay in overbought territory
for some time in strong uptrends. (2 points)
• This oscillator accounts for the up days versus the down days, multiplied by daily volume.
If a day’s average price is higher than the previous days, then there is positive money flow.
In this case we see a continued uptrend in the Money Flow Index (we don’t see a move back
below the overbought line), signifying that volume is also following the advances. (2 points)
7I.
Answer:
• Circle 4. (1 point) The very small body of the candle closed at the high point, well above the
lows earlier in the day.
• This resembles a dragonfly doji, which is bullish. (2 points)
• Based on the fact the resistance line was broken (two white candles above it) it is more likely
that U.S. bond prices will rise in the short term. (2 points)

29
Question #8: System Development
8A. Answer:
Increases (3 points)
As the number of rules increases, the chance that one set of rules will give extraordinary results
increases, increasing the odds of randomness. The smaller the number of rules, the lower the odds
that one set of rules will stand out. (7 points)
8B.
Answer:
Decreases (2 points)
The greater the number of observations (trades) used to compute the performance statistics, the
smaller the dispersion of the statistic’s sampling distribution. The more observations (trades) that
are in the sample, the lower the odds that a lucky few will result in a high mean return. (3 points)
8C.
Answer:
Increase (2 points)
A higher correlation among the rules has the effect of reducing the number of rules, whereas a
lower correlation has the effect of increasing the rules. The more dissimilar the rules, the greater
the opportunity to have a great coincidental fit to the historical data, and therefore very high
performance due to good luck. (3 points)
8D. Answer:
Increase (2 points)
Within a constant sample size, a greater number of extreme values can create a large data mining
bias. The size of the bias will depend on how extreme the values are and how many observations
(trades) are in the sample. With a small sample size even one or two extreme positive values can
dramatically boost the sample mean. (3 points)
8E.
Answer:
Higher (2 points)
If the rules have approximately the same merit, the difference in performance will be due
primarily to luck. However, if one rule begins to stand out statistically, it will be selected most
of the time since its predictive power is greater than the other rules, and therefore its data mining
bias is lower. (3 points)

30
8F.
Answer:
The number of observations (trades) is the single most important factor in reducing randomness.
Acceptable references: law of large numbers, greater amount of testing under variety of
conditions, robustness in backtesting, and so on.

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