Technical Analysis of Financial Markets: Regime, Relative Strength, and Confirmation
What Level III tests
This domain tests whether you can turn chart evidence into portfolio decisions rather than isolated pattern calls. You must identify the market regime, rank opportunities by relative strength, confirm with breadth, intermarket, and sentiment data, and state the invalidation level before acting. The exam rewards a documented, repeatable process and penalizes single-indicator conclusions.
Core rules and concepts
- Trend hierarchy. Use the 200-day or 40-week moving average for the primary trend, the 50-day for the intermediate trend, and price action for timing. A rising long-term average with higher lows defines an uptrend; a flat average means range conditions.
- Relative strength. Compare a sector or security with a benchmark using a ratio line. A rising ratio line plus a rising price is leadership; a rising price with a falling ratio line is market beta, not leadership. Relative Rotation Graphs plot the RS ratio against RS momentum.
- Breadth. Track the advance-decline line, percent of stocks above the 200-day average, and new highs minus new lows. Narrow breadth at index highs warns that participation is fading.
- Intermarket confirmation. Watch Treasury yields, the dollar, credit spreads, and commodities. Falling yields and widening credit spreads often precede equity risk-off phases.
- Sentiment extremes. Put/call ratios, fund flows, and investor surveys are contrarian only at extremes, not timing tools by themselves.
- Signal aggregation. Require independent confirmations and predefine what would prove the thesis wrong.
Worked example
A global equity portfolio is benchmarked to ACWI. The ACWI 40-week average is rising, 62% of constituents are above their 200-day averages, and the semiconductor relative-strength ratio versus ACWI makes a higher high. The 10-year yield breaks below its 50-day average while the dollar is flat. The equity put/call ratio is 1.15, elevated but not extreme. You overweight semiconductors, raise portfolio beta modestly, and place the invalidation at a close below the 50-day average or a 2xATR stop. Reasoning: trend and breadth confirm price, relative strength identifies leadership, and the stop converts the thesis into defined risk.
Traps that cost marks
- Calling a high RSI "relative strength"; RSI is momentum, not comparative performance.
- Treating one breadth divergence as a sell signal without price confirmation.
- Using hindsight-selected indicators or overfitting parameters to one regime.
- Ignoring liquidity and gap risk when translating a signal into a position.
- Failing to state the invalidation level and time horizon.