Mock Exam B.pdf

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Mock Exam
B

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Level 3 Mock Exam — Questions
Question #1: Ethics (12 Points)
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1A. Jorge Salvador, CMT, is a technical analyst for a buy-side firm. He works researching developing
countries with rapidly modernizing economies. Securities laws in these countries are not as
extensive as elsewhere. When Jorge is approached by a corporate owner within one of these
countries, which of the following is correct? (2 points)
A. Jorge does not to worry about violating rules and laws governing insider information.
B. Jorge must write a report of all his communications and inform management periodically.
C. Jorge may be required to abide by the requirements of the Code and Standards even if there is
a distinction between rules of the code and developing country.
D. Jorge does not need to be concerned about U.S. rules since he is researching a developing
country.
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1B. Bobby Guyer, CMT, manages several discretionary accounts for clients as a Registered
Investment Advisor. Bobby has begun to use Twitter messages to communicate new ideas he
is looking at as possible short-term trades in his client portfolios. His clients love getting the
information because they feel he is keeping them up to the minute. The problem is that about
half of his client accounts are not suitable for such trades. Bobby has not communicated with
these clients about the difference in the trades he sends out on Twitter. Some of the clients he has
have begun to ask for more information about how they can participate in such trades, which is
Bobby’s intent.
Which of the following is most accurate regarding Bobby’s de facto marketing
behavior? (2 points)
A. Bobby is not in violation of Standard III(C) because his communications comply with the
existing guidance and regulation governing use of social media.
B. Bobby is not in violation of Standard III(C) because he does not force any trades on his clients.
C. Bobby is in violation of Standard III(C.2) because his recommendations are not consistent
with the original mandate given him for half of his clients.
D. Bobby is in violation of Standard III(C) because he manages discretionary accounts.

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1C. Scott Fielding, CMT, is a strategist for a firm that manages high-net-worth portfolios at a large
global bank. The director of sales has asked him for some figures to help launch a new specialized
fund offering based on one of his strategies. The director is looking for a five-year track record.
Scott has only one year of out-of-sample data trading the system; the other four years are a back
test. The director persuades him that the firm should publish all five years of data.
Which of the following statements is most likely correct? (2 points)
A. Scott and the director have solid data on the strategy so they are not misrepresenting the
performance over the past five years.
B. Scott and the director have violated Standard II(A) by sharing material nonpublic
information.
C. Scott and the director have violated Standard I(C) by misrepresenting their data as actual
performance data instead of theoretical modeling and backtesting.
D. Scott and the director have violated Standard III by not dealing fairly with the clients.
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1D. Shelly Ulsterlow, CMT, is a senior technical analyst for an investment banking firm. She is
frequently asked to make media appearances on market conditions. In the course of a recent
appearance, her interviewer asked her about a sizable position her bank was rumored to have
purchased in a pre-IPO company. Although Shelly didn’t know anything about this situation, she
did not want to appear uninformed about her own company so she acknowledged the rumor and
began to articulate information she assumed would be correct.
Which of the following statements is most accurate? (2 points)
A. Shelly is protected by the First Amendment of the U.S. constitution and can say whatever she
wants as part of journalistic license.
B. Shelly is not in violation of any of the CFA Standards of Professional Conduct.
C. Shelly is in violation of multiple standards listed in the CFA Standards of Professional
Conduct.
D. Shelly is in violation of only Standard II(B) because her statements may manipulate the
perceived market value of the pre-IPO company.

5
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1E. Ren Griswold, CMT, manages a portfolio of managed futures accounts for several institutional
clients. He invests in various spread strategies involving a number of commodities. Ren has
a hunch that gold prices are about to soar higher. In the past his hunches have been highly
profitable investments, so he asks his technical analyst to draft up a bullish outlook for gold that
he can use to help persuade his clients to allocate more money toward gold than his mandate
normally allows.
Which of the following statements about Ren is the most accurate? (2 points)
A. Ren should act with prudence and care by doing the analysis himself so that it is not likely to
be in violation of Standard III(A).
B. Ren should do the analysis himself because the data is likely to be misrepresented otherwise.
C. Ren’s associate is not likely to be objective with his report and sharing that information
would be in violation of Standard I(B).
D. Ren’s associate is not likely to be objective with his report and sharing that information
would be in violation of Standard II(D).
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1F. James Bunson, CMT, is a proprietary trader who has been trading a system he has developed and
refined over the past five years. His firm intends to soon use the system in an automated fashion
as part of their CTA business. James finds one day that his performance data has inadvertently
been overstated for the past year by about a third. Because the firm is only two weeks away from
launching their offering, James decides to say nothing.
Which of the following statements is most likely to be accurate? (2 points)
A. James is not yet in violation of any standards.
B. James’s system still makes money even if the performance is slightly overstated, so it really
doesn’t matter that he may be off the mark just a little.
C. James is in violation of Standard III(D) by not ensuring that the data is accurate.
D. James is in violation of Standard IV(A) by being disloyal to his employer.

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Question #2: Behavioral Finance (25 Points)
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2A. Identify which five of the following are phases of an asset bubble as Montier describes them
(5 points, 1 point each), and give a description of each (4 points per description):
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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Question #3: Asset Relationships (25 Points)
Use the following information to answer questions 3A through 3D.
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? (5 points)
A. Staples
B. Tech
C. Telecom
D. Utilities
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3B. Give two reasons why small-cap relative strength suggests you should add to this
sector. (10 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? (5 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)

8
Question #4: Risk Management (40 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. What method might you use to test your
hypothesis and determine the probability of your trading system succeeding? (4 points)
Briefly describe that testing method and its meaning. (6 points)
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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. (6 points total, 2 per answer)

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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. (8 points)

10
Question #5: Classical Methods (40 Points)
Use Chart 5-1 to answer question 5A.
Chart 5-1

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017-L3CMMEB017
5A. You are newly hired on to 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. (16 points, 4 for each of the four points of evidence)
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. (12 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 dollars 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)? (12 points)

13
Use Chart 6-1 to answer questions 6A through 6C.
Chart 6-1: 10-Year U.S. Treasury prices
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6A. Identify which circle contains the candle (1, 2, 3, or 4) that was most significant in forecasting a
break above the resistance line. (5 points)
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6B. Explain two reasons for your selection in 6A. (5 points)
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6C. What is your short-term forecast for U.S. Treasury bond prices based on this chart? (10 points)

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Use Chart 7-1 to answer questions 7A through 7C.
Chart 7-1
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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 recommend
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? (2 points)
Name and discuss the implication of the two most recent multi-day candlestick patterns that
support your conclusion (4 points each, for a total of 8 points). For each candle, comment if
there is anything significant in the chart that increases the strength of each candle pattern?
(3 points each, for a total of 6 points; 16 points total for question)
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7B. In Chart 7-1 how do the indicators Williams %R and ATR factor into your analysis? (5 points)

15
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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 7F.
Chart 7-2: GDX
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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. 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 money flow, 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)

17
Question #8: Risk Management (38 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
defines five factors that determine the magnitude of the data mining bias (Aronson, David R., Evidence-
Based Technical Analysis, Chapters 5 and 6). Answer the following questions regarding each of them.
The general idea behind these questions is to address the idea of randomness—less is good, and more is
bad. Acceptable answers can use any combination of random, randomness, predictable, predictability,
unpredictable, good luck, bad luck, data mining bias, and other similar words.
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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. Do more observations (trades) increase the bias or decrease the bias?
Explain one reason why. (10 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 (above) is the most important in reducing the data mining bias
(randomness)? (3 points)

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

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Question #2: Behavioral Finance
2A. Answer: B C E F G
Displacement: Exogenous shock triggers creation of profit opportunity in some sectors while
shutting down others. Opportunity created is greater than those shut down. Investment picks up to
exploit new opportunity.
Credit creation: Boom exacerbated by monetary expansion/credit creation. Easy money leads to
price increases.
Euphoria: Speculation for price (momentum) is added to investment for production. Adam Smith
referred to is as overtrading. Overestimate of future returns or excessive gearing.
Critical stage (financial distress): Insiders take profits and cash out. Significant insider selling.
Financial distress is when a firm contemplates not meeting its liability obligations. As distress
persists, perception of the crisis increases. Bank failures.
Revulsion: Paralyzed with fear, investors can no longer participate. Capitulation is generally used
when a bull finally admits defeat.
Montier, Behavioural Investing, Chapter 36, “The Anatomy of a Bubble” (e-book Chapter 29)

20
Question #3: Asset Relationships
3A. Answer: B
3B.
Answer:
Small-caps tend to lead large-caps coming out of bear markets. (5 points)
Tech is typically an early cycle leader. (5 points)
3C.
Answer: A
3D. Answer:
China is the world’s largest producer and consumer of copper.
Katsanos, Markos: Intermarket Trading Strategies, Chapter 3 (Chapter 14 in e-book)
Weigand, Robert A.: Applied Equity Analysis and Portfolio Management, Chapter 2 (Chapter 21
in e-book)

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Question #4: Risk Management
4A. Answer:
Possible answers (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 permutation. (4 points)
This method estimates the sampling distribution’s shape by randomly resampling the original
sample of observations so as to produce new computer-generated samples. This in turn generates
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 to 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. (6 points)
Kirkpatrick and Dahlquist (2011)
4C.
Answer: D
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. (2 points)
2. We can cut back on trading or stop trading trend-following systems completely when
our equity curve declines by a predefined amount. Kirkpatrick and Dahlquist (2011), on
page 577, wrote that a standard for closing the entire portfolio model is a percentage stop,
usually around 20%. (2 points)
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. (2 points)
Kaufman, pp. 1032, 1063

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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.
Kaufman, p. 1037, 1038
Kaufman, Perry: Trading Strategies and Methods, Chapter 23 (Chapter 12 in e-book)
Kaufman, Perry: Trading Strategies and Methods, Chapter 21 (Chapter 10 in e-book)
Aronson, David: Evidence-Based Technical Analysis, Chapter 5 (Chapter 23 in e-book)

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Question #5: Classical Methods
5A. Answer:
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. (4 points)
2. The last day of coffee price action traded below the PSAR indicator, which is bearish.
(4 points)
3. The slow stochastic is still bearish from the last overbought reading above 80 when the
%K line crossed the %D line. (4 points)
4. Potential short-term double top. Coffee prices failed to rally above the recent high at
$208. Bearish. (4 points)
Hold (wait).
Recent coffee price action is converging at four major support levels:
1. At the lower Bollinger band level
2. At the Fibonacci 38.2% retracement level
3. At the MVWAP level
4. At the $175 price, which is short-term price consolidation support between the recent two
highs
(Kaufman, p. 790, e-book 229)
(e-book 6, 175, 1040, 1177)
5B.
Answer:
Two signals that are supportive of a short position are
1. Rising prices on declining trade volume divergence.
2. Rising prices and declining RSI momentum divergence
Others may be possibly noted.
(e-book 5, 47, 48, 271)
5C.
Answer:
1.5% of $5MM 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.
(e-book 473—Method of trades with equal initial position risk)

24
6A. Answer:
Circle 4
(e-book 932)
6B.
Answer:
The very small body of the candle closed at the high point, well above the lows earlier in the day.
(4 points)
A named price pattern here such as long lower shadow, hammer, or even dragonfly doji or any
other bullish pattern would be awarded extra. (5 points)
(e-book 932–934)
6C.
Answer:
Based on the fact the resistance line was broken and both closed near the high (2 white candles
above it) it is more likely that U.S. bond prices will rise in the short term.
(e-book 946)

25
7A. Answer:
Long. (2 points, but if candidate selects “short,” then they lose all 7 points for this question)
Separating lines is the most recent pattern. (4 points)
For separating lines, one of the following counts:
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. (3 points)
Bullish engulfing is the next-most-recent pattern occurring around Oct 15. (4 points)
For bullish engulfing, one of the following counts:
This is also reversal pattern, occurring near the bottom. (3 points)
The bullish engulfing candle engulfs two prior (small-body) candles, increasing its significance.
(3 points)
(Optional) Some candidates may suggest 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). (4 points)
Reference: See Nison, 82–84. Also, since this question is asking for a multi-day candle pattern,
the window does not count for credit.
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). There are a couple of 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. (2 points)
(e-book 549)
(e-book 259–260)

26
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)
(e-book 293–303)
7D. Answer: D
Circle 4 contains an advance block pattern, which consists of three successively smaller white-bodied
candles during an uptrend. It is not an advancing white soldiers pattern. Typically, the standard
forecast for an advance block is that the trend stalls or reverses, which is clearly not the case here.
Nison, p. 99
7E.
Answer:
Advance block or deliberation (either is acceptable)
7F.
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 day’s, 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)
(e-book 5)

27
Question #8: Risk Management
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 (3 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. (7 points)
8C.
Answer:
Increase. (2 points)
Note: Uncorrelated rules will increase bias; correlated rules will decrease bias. Both statements
are acceptable.
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)

28
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)
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, etc.

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