Mock Exam D.pdf

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Level 3 Mock Exam — Questions
Question #1: Ethics (12 points)
001-L3ETMED001
1A. Larry Johnson, CMT, was playing in a charity golf match where he overheard the CEO of a local
company tell another executive that his company was planning to buy a major competitor and
that the deal would be announced within the next week or two. After the match, Johnson hurried
home to look at the charts of both the acquirer and the target company. The chart of the acquiring
company’s stock showed a price pattern that significantly outperformed the weaker company’s
stock price over time. Although it was difficult for him to recommend the target company based
on his research alone, Johnson modified his analysis to conclude with a buy recommendation
since he believed a deal was just around the corner.
Which of the following statements is most accurate? (2 points)
A. Larry did not violate Ethics Standard 5 regarding insider information.
B. Larry violated Ethics Standard 1 regarding professional competence, integrity, and judgment
by reviewing a company he heard someone else talking about.
C. Larry violated Ethics Standard 5 regarding insider information by changing his
recommendation to match insider information.
D. Larry committed no violation and is protected from legal action under the mosaic theory
concept.
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1B. A buy-side client calls Emma Davidson, CMT, to ask her opinion on a small-cap stock that is
generally not followed by the major brokerage houses, and is also not followed by Emma. After
looking at the stock with the client, Emma and the client agree that this stock has a very positive
near-term price trend. Emma places an order to buy the stock right after the phone call, and then
publishes a buy recommendation a week later.
A. Emma has not violated Ethics Standard 8 because she only spoke with a single client.
B. Emma has violated Ethics Standard 1 by behaving unprofessionally.
C. Emma has violated Ethics Standard 7 by making a purchase before giving clientele adequate
time to act on recommendations.
D. Emma has not violated Ethics Standard 7 because she was discreetly communicating with a
very important client with whom her firm shared a nondisclosure agreement.

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003-L3ETMED003
1C. Duke Perry, CMT, recently took a job with a new firm. In addition to his personal effects, he
brought with him the client list from his previous firm, which included contact information for all
the clients. He gave the list to the head of sales at his new firm, encouraging her to use the contact
information to prospect for new clients.
A. Duke has not violated Ethics Standard 8 because the head of sales only spoke with a single
client.
B. Duke has violated Ethics Standard 1 by behaving unprofessionally.
C. Duke has violated Ethics Standard 7 by making a purchase before giving clientele adequate
time to act on recommendations.
D. Duke has not violated Ethics Standard 7 because the head of sales was discreetly
communicating with a very important client with whom her firm shared a nondisclosure
agreement.
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1D. Andy Shea, CMT, writes a blog summarizing the work of many other analysts. On one occasion
she took the trouble to offer her critique of a few of the ideas and on the work of Analyst #5; she
added, “For what it’s worth, I doubt the credibility of this analyst’s outlook because there are
rumors this recommendation is based on data from unreliable sources. I can’t believe anyone
would publish this. Is it a joke?”
A. Andy has violated Ethics Standard 1 by behaving unprofessionally.
B. Andy has violated Ethics Standard 2 by making misleading statements.
C. Andy has violated Ethics Standard 3 by not fully documenting her claims.
D. Andy has violated Ethics Standard 4 by indefensibly disparaging and attempting to discredit
the analytical work of others.

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1E. Adam Scott, CMT, is employed as a technical analyst in the research department of High Point
Advisors. Adam has identified what appears to be a high-volume downside breakout from a
multiyear price pattern on IBM. The target for this pattern is large, and represents the potential
for at least a 30% decline in the price of the stock over the next year. Additional technical
indicators confirm a negative outlook for this stock in the near term, and Adam has noticed
two studies which indicate that patterns like this one tend to hit their price target 70% of the
time. Adam publishes this statement as part of his research and recommendation: “IBM stock
looks like it is in trouble. It might be for any number of reasons, but the price pattern indicates
weakness and the stock may fall as much as 30% in the coming year. Historical data confirms
that patterns such as these predict a downward move to their target more often than random price
moves would suggest.”
A. Adam has not violated any of the Ethics Standards.
B. Adam has violated Ethics Standard 2 by making misleading statements.
C. Adam has violated Ethics Standard 3 by not fully documenting his claims.
D. Adam has violated Ethics Standard 1 by behaving unprofessionally toward IBM.
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1F. Vickie Martin, CMT, CFA, is an analyst at JBT Capital. Vickie’s background includes master’s
degrees in both accounting and economics and she is sought after as an expert in coming up with
valuation estimates for her management team. They often look to her when they contemplate
acquisition of other companies. In addition to her analysis of a company’s balance sheet, she
also takes market sentiment and price trends into account if the company is publicly traded. In
a recent report Vickie analyzed the fundamentals of a company under consideration, and also
looked at the trends of the Asian stock, currency, and commodity markets in which this company
does all of its business. She concluded that the target company was growing and performing well
right now and that it was a good acquisition for her firm to consider. She also added this idea: “It
is possible that the firm might wait and make a better acquisition. Regional conditions may weigh
heavily on the company and its customers, causing its share price to decline, and allowing JBT
Capital to acquire the company at a discount.”
A. Vickie has not violated any of the Ethics Standards.
B. Vickie has violated Ethics Standard 2 by making misleading statements.
C. Vickie has violated Ethics Standard 3 by publishing a recommendation on which technical
analysis had no relevance.
D. Vickie has violated Ethics Standard 5 by participating in insider trading.

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Question #2: System Development (40 points)
Use the following information to answer questions 2A through 2H.
You work for a private equity firm that occasionally has large amounts of cash for short periods of time.You
have been asked to create a strategy to generate substantially higher returns on your firm’s cash positions.
The strategy must have the cash readily available and have minimal exposure to macro events and to
overnight risks in the markets. You have determined that trading a list of retailer stocks intraday using a
reversion-to-the-mean strategy meets all the general requirements:
• It is a sector they are comfortable with.
• There is no overnight gap risk.
• If implemented properly, volatility can be very low.
• They can be out of the market when important economic data is being released, such as the FOMC
meeting.
• The cash is immediately available when needed.
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2A. In addition to the general benefits of intraday strategies, which of the following is an important
consideration for mean-reverting strategies compared to trend-following strategies? (2 points)
A. Mean-reverting strategies typically have less than half the slippage of trend-following
strategies.
B. Mean-reverting strategies enter new long positions as prices move higher and sell short as
prices decline.
C. Total cost of commissions is generally higher for mean-reverting strategies.
D. Mean-reverting strategies typically have lower win/loss ratios than trend-following strategies.
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2B. The strategy that the analyst is testing has only one rule that generates signals. If the analyst
added additional rules to the test, we could expect which of the following? (3 points)
A. The additional rules would make the system more accurate and predictable.
B. If the additional rules are uncorrelated with the first rule and with each other, the degree of
randomness should decline.
C. If the additional rules are highly correlated with each other and with the first rule, the degree
of randomness should remain approximately the same.
D. If the new rules are designed to eliminate a small number of large losses, the system will be
more robust.

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The schedule in Chart 2-1 contains a summary of the results for six stocks that you evaluated, using
traditional backtesting techniques. The next step will be to perform a walk-forward test on the best names
from this list. You must now address each of the following questions to eliminate the stocks that should be
removed from further consideration.
AMZN COST CVS HD TGT TJX
Total Net Profit $11,306 S9.053 $10,130 $11,333 $8,632 $7,157
Profit Factor 1.45 1.67 2.21 1.91 1.71 1.53
Total Number of Trades 160 141 82 85 70 87
Percent Profitable 57.5% 59.6% 58.5% 62.4% 57.1% 54.0%
Return on Initial Capital ($100,000) 11.3% 9.1% 10.1% 11.3% 8.6% 7.2%
Buy Hold Return 17.1% –10.3% 1.8% –2.1% –0.5% –4.7%
Annual Rate of Return 43.4% 35.1% 39.1% 43.5% 33.5% 28.0%
Std. Deviation of Annual Return 9.8% 4.7% 5.2% 5.8% 4.5% 3.7%
Percent of Time in the Market 16.3% 15.8% 13.4% 15.7% 15.3% 14.7%
Max. Drawdown (Trade Close to Trade Close)
as % of Initial Capital 3.8% 1.9% 1.6% 2.7% 2.3% 4.0%
Net Return as % of Drawdown 297.6% 481.4% 617.7% 424.3% 381.9% 179.0%
Avg. Trade Net Profit $70.67 $64.21 $123.54 $133.33 $123.32 $82.26
1 Std. Deviation of Avg. Trade $552.09 S354.69 $431.58 $576.77 $627.36 $541.42
Normalized T-Test 1.3 1.8 2.9 2.3 2.0 1.5
p-value 0.102 0.036 0.003 0.011 0.026 0.066
Information Ratio XXX 7.53 7.48 7.44 7.53 7.59
Chart 2-1
009-L3SDMED009
2C. The information ratio is an important factor to consider when evaluating trading strategy
performance. Because mean-reverting intraday systems tend to have very high information ratios,
you determine to calculate the information ratio of your trading system on each stock. Calculate
the information ratio for AMZN. (5 points for the correct result, 0 points for an incorrect result
if only the result is provided, 4 points if just the definition is supplied or if the equation is set up
using the correct numbers but the math is incorrect) (5 points)

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010-L3SDMED010
2D. Are any of the information ratios so low that they should be eliminated from further
consideration? Explain. (5 points)
Note: For comparison purposes, the long-term information ratio for the SP 500 is approximately
0.6, and 1.2 for the typical long/short fund that holds positions overnight. The information ratio for
the private equity firm’s portfolio is approximately 2.0.
011-L3SDMED011
2E. The p-value and its complement, the student’s T-test, are among the most important factors for
determining predictability from a group of trades. Using the data from the backtests, determine
which outcomes are too random and should be dropped from further consideration and base your
analysis on either the p-value or the T-test. (5 points)
012-L3SDMED012
2F. The firm wants to use 2× leverage for each position, while limiting their target risk to 15% per
name. Back tests usually understate drawdowns, so it is common to assume that the largest future
drawdown will be 3× what was seen in a back test. Are any of the drawdowns too large to meet
the leverage requirement and so should be dropped? (5 points)
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2G. All of the tests are in the market about 15% of the time. Significantly increasing the time in the
market would likely do which of the following? (5 points)
A. Not change the risk/reward profile very much.
B. Increase the returns and lower the risk.
C. Increase the returns and increase the risk.
D. Lower the returns and lower the risk.
014-L3SDMED014
2H. Which three stocks would you keep for the walk-forward testing? Specify three reasons why you
chose those three. (10 points)
The three stocks to keep are (COST, CVS, TGT). (5 points)

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Question #3: Asset Relationships (35 points)
Use Charts 3-1 through 3-3 as indicated to answer questions 3A through 3E.
Chart 3-1: Weekly Chart on Dow Jones Industrial Average (DJIA)

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Chart 3-2: Weekly Chart on Copper Spot Price

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Chart 3-3: Annual Sector Returns
John Dawson is an analyst at JLT Capital LLC who specializes in intermarket analysis. You are his super-
visor and oversee all technical analysis activity for JLT.
015-L3ARMED015
3A. John has compared the DJIA and copper spot price charts for the last two years (shown in
Chart 3-1 and 3-2) and believes the charts show evidence that the Dow may resume its trend.
Describe what evidence the charts have to support John’s observation. (12 points, 4 each)

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Separately from John’s work, you are tasked with forecasting sector rotation based on the usual
progression of a business cycle. Working with the information in this table, often referred to as the U.S.
Sector Periodic Table of Returns, write out your observations for the following:
016-L3ARMED016
3B. Which phase of the business cycle is apparent for Year 1? Describe the evidence you see for
this. (7 points)
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3C. Has the phase of the business cycle changed in Year 2? Describe the evidence that supports your
answer. (3 points)
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3D. Which phase of the business cycle does Year 3 appear to be entering? Describe the evidence that
supports your answer. (3 points)
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3E. Based on your review of the sectors, and John’s review of copper prices, would you give a
favorable recommendation to your firm’s portfolio manager about adding to stock positions for
the coming year? Explain your answer. (10 points)

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Question #4: Portfolio Management and Classical Methods (25 points)
Use Chart 4-1 to answer question 4A.
Chart 4-1

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4A. From 1968 to 1997, stock prices and bond yields had a consistent negative correlation as can be
seen in the bottom of Chart 4-1. Since 1997, stock prices and bond yields have been positively
correlated. Why would this change in correlation cause the NYSE Advance/Decline line to be
less effective? (5 points)
Use Chart 4-2 to answer questions 4B through 4C.
Chart 4-2
021-L3PMMED021
4B. Why would a large-cap manager be interested in the breadth of small-cap stocks? What
could the manager conclude by comparing the most recent breadth of small-cap to large-cap
stocks (Chart 4-2)? (10 points)

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4C. Based on the relative breadth chart, which of the following adjustments should the large-cap
manager consider making to his portfolio? Explain your answer. (10 points)
A. Reduce telecom exposure and increase health care exposure.
B. Reduce utility exposure and increase technology exposure.
C. Reduce financials exposure and increase consumer staples exposure.
D. Reduce consumer staples exposure and increase health care exposure.

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Question #5: Risk Management and Classical Methods (35 points)
Use Chart 5-1 and the following information to answer questions 5A through 5C.
Chart 5-1
You are interviewing with XRHO Capital Management. About six months ago some of that firm’s
analysts recommended the firm take a long position in JJC, so the interviewer is using Chart 5-1 to ask
you questions. You know that this firm seeks to aggressively profit from one-to-three-month swings in
commodities and that they have only a basic knowledge of technical analysis among their staff members.
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5A. Your interviewer explains that he has heard of the concept of divergence, but he doesn’t know
how to recognize it on the chart. He wants to know all of the tradable divergence signals between
the price and the RSI. Describe your answer to his question and the evidence you see to support
that conclusion. (10 points)
024-L3PMMED024
5B. Your interviewer asks you to talk about the trendlines on the chart and explains to you that
the lines were drawn on April 1 (shown by the vertical line in Chart 5-1). He wants to know if
you think the lines are valid as drawn or if you would draw them another way. Explain your
answer. (10 points)

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5C. Lastly, your interviewer tells you their firm is planning to take a long position below $40.00 in the
next few days. He is curious if you see any reason for concern about that idea on Chart 5-1.
Answer his question using all available information on the chart to describe your answer to his
question with the evidence you see to support a cause for concern based on technical analysis
signals. (15 points)

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QUESTION #6: Candlestick Analysis (40 points)
Use the following information and charts to answer questions 6A through 6G.
Ben Craft, a research analyst at your firm, has asked you to review a candlestick chart he plans to use in a
market newsletter. Ben highlighted three sections of the chart, labeled A, B, and C (shown in Chart 6-1).
Examine each of the highlighted candlestick patterns to answer the questions that follow.
Chart 6-1
Chart 6-2

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Chart 6-3
Chart 6-4
026-L3CAMED026
6A. Is the name Ben gave for A correct? Answer “yes” or “no.” If you answer “no,” provide the correct
pattern name. Also explain whether the short-term price action that followed the highlighted
pattern matches the standard forecast for the pattern based on its correct name. (5 points)

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Note to Students: While it may look like a piercing line (as the second candle pierces more than
50% into the proceeding one), piercing lines are reversal patterns. An upward-gapping tasuki is
established by an upward window (or gap). Then, a white candle is followed by a black candle
which closes below the white candle, but doesn’t close the gap. The pattern is confirmed when the
market advances upward.
027-L3CAMED027
6B. Is the name Ben gave for B correct? Answer “yes” or “no.” If you answer “no,” provide the correct
Note to Students: Counterattack lines are reversal patterns. While both a counterattack and a
separating-lines pattern have opposite-colored candles, counterattack lines have the same close, and
separating lines have the same open.
028-L3CAMED028
6C. Is the name Ben gave for C correct? Answer “yes” or “no.” If you answer “no,” provide the correct
Note to Students: A three-white-soldiers pattern is a sign of bullish strength, especially if it occurs
near a low price point, with white consecutive candles showing higher highs. The key is each candle
should close at or near its high point.
029-L3CAMED029
6D. An analyst in your company is ready to place a buy recommendation on the security shown in
Chart 6-2, with the recommendation that it be accumulated beginning at the open of the next
day’s trading session. Explain the evidence you see on this chart that would suggest this decision
may not reflect the best timing. (6 points)
030-L3CAMED030
6E. Your portfolio manager wants an e-mail from you with an explanation of your analysis for
Chart 6-3. Write the body of that e-mail in 10 sentences or less and include the following
information: name and implication of the most recent candlestick pattern; explanation of the
weight of evidence from the chart, including any other indications besides candlestick patterns;
name and discussion of the implications of three prior multiple-bar candle patterns that support
your conclusion. (6 points)

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6F. What is your short-term recommendation for the security in Chart 6-4? Discuss more than one
multi-bar candlestick pattern (name, approximate date, and implication) that supports your
conclusion. In your analysis, include your interpretation of the provided technical indicators:
parabolic SAR, 20-day exponential moving average (EMA), and Relative Strength Index
(RSI). (6 points)
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6G. Based on your answer to the previous question, describe how you would set up a trade based on
that information. (7 points)

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Question #7: Behavioral Finance (23 points)
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7A. Jackson Curtis is a portfolio manager who has twice been named top hedge fund manager in the
world. In order to achieve this honor, he runs a concentrated portfolio of 10 securities. He tells
investors that his portfolio returns have high volatility because he has tremendous belief in his
analysis.
First, name three of the five ego defense mechanisms Jackson would likely use during periods of
poor performance. (3 points)
Second, discuss why, given the dismal forecasting results by professionals, portfolio managers
like Jackson may still include forecasting in their investment process. (2 points)
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7B. Gusharan Kumar is a junior technical analyst for a large global bank. He recently passed the
CMT 3 exam, but does not have enough experience to get his CMT charter yet. He was tasked
with writing his first report on the FX markets, an asset class he has very little experience
analyzing. He read several competing firms’ comments on the markets and based his report on
one of them, but discarded many others.
Identify and explain the bias that Gusharan’s behavior demonstrated. (2 points)
035-L3BFMED035
7C. Investment committees are standard in the investment world and in some cases are legislated.
Groupthink can be a big problem when it comes to investing. We often see conflicting opinions
from the same firm on market direction.
State two conditions where group decisions are statistically useful. (9 points)
State three potential strategies to reduce group biases. (6 points)

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7D. Your firm manages the assets of high-net-worth clients. Many of them have come to you with
questions about your strategy. They have heard that Chinese growth remains above 7%, while the
U.S. economy has been struggling with growth rates far lower (2.5%) than potential. A few of
your firm’s clients have questioned why your firm has so much money allocated to U.S. stocks.
They reason that since the SP 500 has significantly outperformed and currently has a multiple
of 18 (almost double that of China), the Chinese market must certainly represent a better value
right now.
Your portfolio manager wants to know if you have any input on whether the firm should change its
strategy. Suppose you decide to draw on the concept of average GDP growth versus average dollar
stock returns that Montier references, which includes the information in Chart 7-1.
Chart 7-1
Compose your response to the portfolio manager answering this question: Should we be
more heavily invested in China or in the United States right now for at least the coming year?
Why? (7 points)

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Question #8: Classical Methods (30 points)
Use the following information and Chart 8-1 to answer questions 8A through 8E.
Chart 8-1 displays actual historical line charts of daily closing prices for the Dow Jones Industrial
Average (INDU, bottom chart, in blue) and the Dow Jones Transportation Average (TRAN, top chart, in
red). You are a technical analyst for a large and aggressive fund that needs to outperform the INDU. You
are required to interpret and apply the Dow Theory for risk management.
Chart 8-1
Your manager is the portfolio manager of a fund you work for. She reduced long stock positions as stock
prices sagged lower since March. In addition she sold more stock as prices rallied in July. Consequently
she now has the fund underinvested, and it has underperformed since the June lows. She is now anxious
and asks for your current analysis using the Dow Theory as of the current date (late in August).
037-L3CMMED037
8A. What is your analysis based on Dow Theory from the latest confirmed joint new highs by both
averages from marker (1) to the current date? (6 points)
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8B. Identify (as up, down, or neutral) the trends in all three time frames: minor ripple, secondary
reaction, and primary tide major trend, and explain the evidence for each. (6 points)
039-L3CMMED039
8C. What specific price levels occurring after point (2) for both the TRAN and INDU would confirm
a bullish primary tide major trend and, therefore, justify aggressively adding to long stock
positions? Justify your answer. (6 points)

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8D. Your manager thinks that the averages are showing a current bullish trend. Explain whether you
can classify her “current bullish trend” in the averages as a primary, a secondary, or merely a
minor ripple trend. If not, explain why not. (6 points)
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8E. Your portfolio manager is impressed with your analysis so far, but now asks you to tell her the
specific price levels for both the TRAN and INDU that would confirm a bearish primary tide
major trend and, therefore, justify aggressively reducing long stock positions. Name the prices
where the TRAN and INDU would trigger a signal of a major trend change. (6 points)

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

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Question #2: System Development
2A. Answer: A
2B.
Answer: C
2C.
Answer:

The expected annualized return or annualized rate of return divided by the standard deviation of
the annualized return or annualized volatility:
43.4 / 9.8 = 4.43
2D. Answer:

No. The information ratios are all very high compared to the average for the market, the average
long/sort fund, and their internal performance, so none of the tests should be eliminated based on
this metric.
A yes answer gets zero points even if correct logic is provided.
A no answer on its own is 2 points, with 3 additional points (5 total) if correct explanation is given.

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2E.
Answer:

The maximum threshold for the p-value is 0.05, and any value less than that meets the
randomness test. The correct names using this metric are:
COST
CVS
HD
TGT
The minimum threshold for the T-test is 1.7, so any value greater than that meets the randomness
test. However, the Weigand text incorrectly states that the T-test threshold is 2.0, which is
incorrect, so we have to accept either answer: 1.7 or 2.0.
The correct names using the 1.7 threshold are:
COST
CVS
HD
TGT
Using the 2.0 threshold, they are:
CVS
HD
TGT
Either list is acceptable if the T-test is specified as the metric; however, no credit is given if they
say they are basing their selection on the p-value and do not list all four names.
4 points if thresholds are correctly described for either the p-value or T-test, with 1 additional
point if correct names are selected; 5 points if correct names are selected without describing the
thresholds.
2F.
Answer:

Yes. (3 points)
2 additional points if they do any two of the following:
Spell out the calculation. (1 point)
Show correct arithmetic in their calculation. (1 point)
Supply the names or tickers of all three stocks (AMZN, HD, TJX) that should be dropped.
(1 point)

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2G. Answer: C
2H. Answer:
They pass the p-value and/or T-test thresholds (COST would be eliminated using 2.0 for T-test
threshold, so need to use our judgment here). (2 additional points)
2 points if either of the following are mentioned:
Information ratios are very high.
They meet the leveraged risk requirements.
1 point if any of the following are mentioned:
Profit factors are greater than 1.5.
The number of trades is statistically significant.
They are out of the market most of the time.
With only one parameter in the test, curve fitting is minimized.

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Question #3: Asset Relationships
3A. Answer:
• First: Copper is showing subtle relative strength compared to stocks. Conventional wisdom
says that copper tends to lead stocks, and if so, the relative strength in copper prices means
that stocks should continue higher.
• Second: Volume is increasing on the copper charts even as prices rise. The last two weeks
show high volume, but prices don’t drop furiously, so it must be that a good portion of that
volume is buying volume.
• Third: The RSI on the copper chart shows the indicator reaching the oversold level, but it has
only just reached this point, and the trend of the indicator line is still upward.
3B.
Answer:
The late-cycle phase. (2 points)
As the economic recovery matures, the energy and materials sectors, which are closely tied to the
prices of raw materials, have tended to outperform. (2 points)
AND/OR: So do defensive-oriented sectors—those in which revenues are more tied to basic
needs—such as health care, consumer staples, and utilities. (3 points)
AND/OR: Elsewhere, information technology and consumer discretionary stocks have lagged
most often, tending to suffer the worst as investors shift away from economically sensitive areas.
(2 points)
3C.
Answer:
Yes, it has entered the recession phase. (1 point)
As economic growth stalls and contracts, sectors that are more economically sensitive fall out of
favor, including industrials, information technology, and consumer discretionary. (1 point)
Defensive-oriented sectors—such as consumer staples, utilities, and health care—tend to move to
the front of the performance line. (1 point)

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3D. Answer:
The early-cycle phase. (1 point)
Amid an accelerating economy and an easy monetary policy, sectors that typically have benefited
most from a backdrop of low interest rates and the first signs of economic improvement have
tended to lead the broader market’s advance. (1 point)
Interest rate–sensitive sectors—such as consumer discretionary and financials—historically have
outperformed the broader market. (1 point)
AND/OR: Economically sensitive sectors boosted by shifts from recession to recovery—such as
industrials, information technology, and materials—have also performed well. (1 point)
AND/OR: Laggards have included utilities and energy, which generally are more defensive in
nature. (1 point)
3E. Answer:
Yes. (2 points).
Since the price trend of copper still shows bullish relative strength, it implies that the upward
trend for stocks may continue also. (4 points)
This is consistent with being in the early recovery stage of the business cycle (mentioned in the
previous answer). (4 points)
Also acceptable: Since we are in the early recovery stage we can expect that business conditions
are likely to produce upward-trending prices over the next year, especially for stocks in the
Materials and Industrials sectors.

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Question #4: Portfolio Management and Classical Methods
4A. Answer:
Historically stock prices and bond yields reached bottoms at roughly the same time with bond
markets reaching peaks earlier than the stock market reached peaks. Because NYSE breadth
statistics include a lot of interest-related stocks that are not included in the popular averages, this
change in relationship gives the breadth line more strength at tops and more weakness at bottoms.
Kirkpatrick, p.135
4B.
Answer:
Small-cap stocks have a tendency to lead at bottoms. Despite the fact that the manager trades
large-cap stocks, the strength in small-cap breadth can be interpreted as a sign that the market is
nearing a bottom.
Murphy, p. 107
4C.
Answer: B
Murphy, p. 106

33
Question #5: Risk Management and Classical Methods
5A. Answer:
Valid responses (3 points for identifying them, 2 points for explanation of evidence):
1. A bullish divergence at the end of the lower trendline (price ∼38.25 and 37.75) with RSI
below 30 and then later above 30.
Evidence: Lower prices on two red candles, higher RSI reading, second one above 30 increased
volume on second red candle, both lower prices occur on trendline established long before,
second candle has longer shadow.
2. A bearish divergence (marked by dark-red guidelines) at ending at the last touch of
the upper trendline (price ∼42.10 and 42.50), with RSI readings first at 60 and then the
second one just slightly below that—very subtle.
Evidence: Upper trendline, bearish second candle, increased volume on second candle, second
candle showing resistance in former support area (41.50 to 42.00).
5B.
Answer:
Yes, they are valid. (4 points)
(2 points each)
• Lower line includes five touchpoints with no exceptions.
• Upper line includes four touchpoints. The two touchpoints occur after the line was drawn
(in the dashed area).
• Price still shows reaction on trendline even though separated by many candles.
5C. Answer:
(3 points each for anything on the following list)
• Upper trendline still shows resistance.
• Recent bearish divergence on RSI.
• The two touchpoints that occur after the line was drawn (in the dashed area) show
resistance is not done.
• Bearish separating lines in last two candles.
• Bearish final candle breaks former low.
• RSI is trending lower.
• Volume is weakening as trend moves less upward and more sideways over the last
15 candles.
• Broken support implies next downward price target could be 10% lower.

34
Question #6: Candlestick Analysis
6A. Answer:
• No. (1 point) The correct name is an upward-gapping tasuki. (1 point)
• Yes. (2 points) This is a continuation pattern and thus the security did perform in line over the
short-term with the standard forecast of this pattern. (3 points)
Nison, pp. 134–135
6B.
Answer:
• No. (1 point) The correct name is separating lines. (1 point)
• Yes. (2 points) This is a continuation pattern and thus the security did perform in line over the
short term with the standard forecast of this pattern. (3 points)
Nison, p. 150
6C.
Answer:
• No. (1 point) The correct name is an advance block. (1 point)
• Yes. (2 points) This is a reversal pattern. In an advance block, the second and third candles
show signs of weakening. Here we see longer shadows at the tops, with successively
smaller bodies, signifying the rally is running into trouble and longs should protect
themselves. (3 points)
Nison, p. 99

35
6D: Answer:
• The most recent pattern (though unconfirmed) is a dark cloud cover. (1 point)
• The standard interpretation of a dark cloud cover pattern = a bearish reversal pattern. The fact
that this candle penetrated more than 50% into the territory of the prior day’s candle increases
its significance. (1 point)
• Williams %R is a momentum indicator which uses an inverted scale when compared to other
indicators like stochastics or RSI. Thus, since Williams is now trending up (moving away
from extreme overbought), this could be a sign of potential weakness in the most recent
bullish move. (1 point)
• The upper Bollinger band was penetrated in the prior day’s candle, but the dark cloud cover
has now closed under the band. While some may see upward breaks of the bands as a sign of
bullishness (that the uptrend will continue), this chart’s history shows that upward breaks of
the Bollinger band have resulted in a reversion to the mean (a reversal). (1 point)
• Prior resistance is evident on three separate occasions (in late May, mid-July, and early August)
at approximately $53–$53.50. This is near where the most recent candle opened. (1 point)
• Volume on the most recent candle (a selling candle) has increased versus the prior day,
showing that there is more energy behind the potential for a reversal (more significance).
Other answers may point to a slight downtrend in volume as the most recent uptrend
continued, suggestive of weakening momentum. (1 point)

36
6E:
Answer:
• The most recent pattern is high-wave candle(s). A candidate can indicate there were two or
three consecutive occurrences of high-wave candles, or simply mention the last one for full
credit. (1 point)
• A high-wave candle has very long upper and lower shadows and a small real body. When
occurring in a trending market, it may suggest that the market is losing the directional bias
that it had before (trend is weakening). (1 point)
• Other significant candle patterns: (3 total points)
○
○ Rising three methods (late November): This is a bullish continuation pattern, comprised
of five candles. However, it was not confirmed. The market reversed to the downside.
○
○ Harami (early October). The small body occurs within the range of the previous body.
Note: A harami is still valid if its shadows extend above or below the prior day’s full
range. The fact that this pattern occurred after an extended downtrend increased its
strength as a reversal pattern.
○
○ Tweezers top (there are two occurrences: mid-September and late October). When
occurring after an uptrend, this pattern is often a suggestion that the recent move is losing
momentum, failing to recognize a new high.
○
○ Dojis occurring in the middle of a move have no significance; there are several dojis
evident in the chart. However, no credit can be given for naming one that occurs in the
middle of a move, where the move continues its direction.
• Market call/conclusion: There are three acceptable conclusions, but they must be supported
in light of other evidence in the chart. (1 total point)
• The defense of these conclusions must include references beyond candlestick patterns for
credit, such as prior resistance becoming support, and also the trend of volume. Here are
some sample responses:
○
○ The stock will reverse: “I’m bullish on this security. The high-wave candles are
suggesting a weakening of the downtrend, old resistance may be becoming a new support
level, and the fact that there is declining volume on the recent price decline is more
suggestive of a reversal to the upside.”
○
○ The stock will continue to decline: “I’m bearish on this security. Old resistance is being
broken, which should have been a new support level. A lower high was put in over the
past three months, along with declining volume on the last upward swing, followed by an
upthrust where the bulls failed to sustain a new high.”
○
○ The stock will hold (try to find support): “We need to wait and see if the stock holds
here at prior resistance, which could become a new support level. Currently the stock
is in a downtrend, but given the high-wave candles and the fact volume isn’t increasing
as the stock declines, this trend could be slowing/weakening. Thus, we need to wait for
confirmation before engaging in any new trades. We also don’t have a pricing axis, so it
is difficult to determine the best point of entry/stops, etc.”

37
6F.
Answer:
• Short-term recommendation = buy (1 point). This is the only acceptable answer, as there is
not an abundance of other evidence to suggest a reversal to the downside.
• PSAR is a stop-and-reverse indicator. The small dot (most recent) is now beneath the price
action, which indicates that the upward acceleration of the stock is bullish. (1 point)
• RSI is trending up, moving away from the oversold reading, showing a strengthening upward
momentum. (1 point)
• The EMA has been broken to the upside, after a gap up and with the presence of a larger
white candle body, showing strength. The EMA has acted as resistance in looking at the
chart’s history; prior breaks above it have seen a change in trend (to the upside). (1 point)
Prior multiple-bar patterns (need at least two different patterns—2 total points; to get full credit
for each pattern, candidate must name and discuss interpretation of the patterns. If they only
name two patterns correctly, 1 point total is awarded. They must share their interpretation of
at least two patterns to get the remaining 1 point credit). There are several possibilities, but
these candles can’t be simply randomly named. The chosen candles must support the bullish
conclusion. Some of these include:
• Counterattack lines (late June). The long white candle closed where the prior long
black candle closed; since occurring at the bottom of a downtrend, this increased its
significance as a bullish reversal pattern.
• Frying-pan bottom (mid-Aug. to mid-Sept.). Similar to a Western saucer bottom, it began
with a gap down and ended with a gap up. It also occurred at a prior support level from
late June.
• Bullish engulfing (early Oct.). The long white candle not only engulfs the preceding
candle, but it also closes the gap. It is confirmed after the two additional white candles.

38
6G. Answer:
If you described a long entry in the previous question, then assume an entry at $74.21. Specify
the proper stop-loss price based on the most recent PSAR pattern. Also calculate the number of
shares that should be purchased if the position needs to have no more than $20,000 at risk when it
stopped out (assuming you are able to get out of the position at your stop price). (7 points)
If you described a short entry in the previous question, then assume an entry at $73.25. Specify
the proper stop-loss price based on the most recent candle pattern. Again, also calculate the
number of shares that should be purchased if the position needs to have no more than $20,000 at
risk when it stopped out (assuming you are able to get out of the position at your stop price).
• PSAR can be used to help establish a trailing stop price, and is recalculated daily based
on the price action/acceleration factor. The most recent trailing stop (based on the
most recent small dot beneath latest price action) is $71.51. Note that this PSAR level
is also near prior levels of support during the frying-pan bottom formation in August
(approximately at $72). (3 points)
• For a $20,000 max loss, this means the trader could purchase 7,380 shares at an entry price
of $74.21. (MATH = 74.21 – 71.51 = $2.70 risk per share . . . 20000 / 2.70 = 7380 shares).
(4 points)
• Note: If the candidate suggests a short entry and buy to cover (using a prior PSAR level),
then 0 points will be awarded for the entire question.

39
Question #7: Behavioral Finance
7A. Answer:
1 point for each point made similar to these:
1. The “if-only” defense: If the Fed had only raised rates as I expected. But don’t worry,
they will . . .
2. The “ceteris paribis” defense: Although the forecast may have been correct at some
point, something changed it along the way. The market was crashing until the Fed printed
money.
3. The “I was almost right” defense: Well, it almost hit my price target, so I never sold it,
but I still like it at this level. It would have hit if the EU did not almost break apart.
4. The “It just has not happened yet” defense: It will eventually work, be patient.
5. The “single prediction” defense: Everything that I forecast happened; just the market did
not do what it should have.
Montier, pp. 115–117
2 points for reference to efficient market hypothesis (EMH) being consistent with needing to
know more than everyone else to outperform. One way of knowing more is to forecast the future
better than anyone else.
Montier, pp. 119–120
7B.
Answer:
“Show me what I want to see” or “Confirmatory bias”
(2 points) Analyze: When Karl Popper wrote his philosophy of science he stated that the only
way of testing a view was to state the hypothesis and spend the rest of the day looking for things
that disagree with it. Unfortunately, most people are not wired that way. We tend to form a view
and spend the rest of the day looking for things that agree with it.
Also valid: Our natural tendency is to listen to people who agree with us. It feels good to have
our opinions reflected back to us. We get a warm-and-fuzzy feeling of contentment. What we
should do is sit down with people who disagree with us. Not to enable us to change our minds,
but to make us aware of the alternative point of view. We should look for the logical error in the
opposite point of view. If we cannot find such an error, we should not hold our own point of view
as strongly as we probably do. We also tend to suffer from hostile media bias. Not only do we
look for information that agrees with us, we tend to view others with the opposite viewpoint as
being biased. We typically do not understand that we will be wrong a significant amount of the
time.
Montier, Chapter 2, “The Biases We Face,” pp. 23–24

40
7C.
Answer:
If these conditions are broken, the group advantage is quickly lost:
1. People must be unaffected by others’ decisions (errors must be uncorrelated).
2. Probability of being correct must be independent of the probability of everyone else
being correct.
3. Participants must be unaffected by their own vote possibly being decisive.
Montier, p. 211
1. Secret ballots
Reduces risk of social pressure. Come to meetings with views prewritten or preference
for asset allocation.
2. Devil’s advocate
It is a nice idea, but in order to be effective, the person needs to actually believe the
counterview.
3. Respect for other group members

Understand that other members are acknowledged experts in their field. However, people
tend to believe they know more than others in almost every subject. This is especially
prevalent in financial services.
Montier, p. 215
7D. Answer:
United States. In the book, Part 1 suggests the United States, and because the question only draws
on Part 1, the correct answer is the United States.
Other valid explanations:
Explanations that include the fact that the United States is expensive and China is cheap, so China
is probably the better investment, if they also mentioned that growth is not the panacea of investing,
but in the case of China, the higher growth is not priced in like it was in the pre-crash (2008) period.
If they choose China, and mention higher growth not being priced in, then give 2 points. But if they
don’t mention the qualification of severely reduced prices after 2009, then only give 1 point.
Montier, Chapter 15, “The Story Is the Thing” (“The Allure of Growth”) p. 195, Chart 15.3
(1 point) The relationship is actually inverted.
(2 points each for the following observations)
• Economies with the lowest growth rates seem to deliver the highest forward returns.
• Investors overpay for growth.
• Low-growth economy has its valuation already discounted.
Montier, p. 194, Chart 15.2

41
Question #8: Classical Methods
8A. Answer:
From March into June, both averages endured typical downside secondary reactions that were
interrupted by several minor-ripple rallies, which are of no significance in Dow Theory.
From the June lows into July, Both INDU and TRAN had upside secondary reactions. Since
TRAN high at 5505 on 7/24 to the current date of 8/21, TRAN has surrendered about two-thirds
of its June–July rally over four weeks, qualifying as a downside secondary reaction for the TRAN
alone—without confirmation by the INDU. Since that TRAN high at 5505 on 7/24, the INDU has
continued and extended its solo upside secondary reaction from its June low and is currently in an
insignificant downside minor ripple.
8B.
Answer:
Primary Trend: Not available, based on the information given. The chart and information given
only shows secondary reactions and minor ripples.
Secondary Trend: Up, but becoming less certain since August 20. The secondary trend was
clearly up from point 2 in June until the TRAN signaled its solo secondary reaction to the
downside by falling to a lower low on August 20. Meanwhile, the INDU continued its upside
secondary reaction from its June low with only insignificant minor ripples to the downside. So,
before changing the rating of the secondary reaction from up to down, we must await downside
confirmation by the INDU.
Minor Ripple Trend: Down. The recent move has taken out the previous minor-ripple lows for
both the INDU and the TRAN.
8C.
Answer:
A move by the INDU above its March high at 194.40 together with a move by the TRAN above
its July high at 5505 would signal a bullish primary trend and thereby justify adding to long stock
positions.

42
8D. Answer:
First, it is important to note that we cannot know anything about a “current bullish trend” based
on the information given. The averages are giving mixed signals. From the June lows into July,
both INDU and TRAN had upside secondary reactions. Since TRAN high at 5505 on 7/24 to the
current date of 8/21, TRAN has surrendered nearly two-thirds of its June–July rally over four
weeks—but that is only halfway to qualifying as a downside secondary reaction. Only when the
INDU confirms a similar decline will we have an actual downside secondary reaction.
Since INDU high at 190.02 on 8/14 to the current date of 8/21, INDU has surrendered less than
one-third of its June–August upside secondary reaction rally in just one week, qualifying this
small move as nothing more than a downside minor ripple, which is of no significance in Dow
Theory.
8E.
Answer:
Because the rally by both averages since June recovered significant fractions of the previous
decline and lasted more than three weeks, that rally qualifies as an upside secondary reaction,
which is important for judging Dow Theory major signals. Currently, as of the end of the chart
on 8/21, and based on the chart and information given, we do not know what the primary trend is,
but we do know that a break by both averages below their June lows would signal a primary tide
bearish major trend. Specifically, if the INDU closes below 165.51 and the TRAN closes below
5017, the Dow Theory would signal a bearish primary tide major trend.

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