The Arnaud Legoux Moving Average (ALMA) is a variation of the traditional simple moving average.
The calculation is based on a weighted sum over a specific time-period, the Gaussian filter offset and sharpened by standard deviation. A moving average is applied twice, from left to right and vice versa.
Here’s the formula for those you interested.
Figure 1.1 ALMA Calculation
If the formula goes over your head: don’t worry!
We aren’t going to discuss the equation.
Here’s a short video explaining the indicator, when to use it, and testing against the EMA and SMA.
If you’d rather read, just skip the video and continue the article!
The primary advantage of the ALMA lies in its propensity to hug price movement tightly; prices can sustain above ALMA only when an uptrend is hot, or below the ALMA when a downtrend is hot.
If a trend exhausts, prices cross over/under the ALMA rather quickly.
Figure 1.2 ALMA 200 vs. EMA 200 vs. SMA 200 During COVID Sell-Off
If we had implemented a basic price/ALMA crossover system before, during, and after the COVID sell-off we would have exited long early in the crash and converted to short. In addition, we would have exited short and converted to long during the bullish reversal than possible with the EMA 200 and SMA 200.
The ALMA is generally smoother and more responsive than commonly used moving averages
The indicator was designed to generate unambiguous, transparent signals based on price crossovers. It’s safe to assert the indicator achieves this goal; the smoothness of the trend allows for conspicuous crossovers.
Disadvantages of ALMA
There are two predominant issues associated with this moving average.
- High responsiveness often results in false signals/whipsaws; we might be signaled to exit a trend due to a simple retracement.
- The ALMA does not have fulfilling propertiess
Disadvantage #1 is an issue to some traders, but not all traders. If you only enter and remain in a trend while it’s progressing and you aren’t willing to hold during retracements, then this disadvantage #1 might actually be an advantage.
Disadvantage #2 is concerning for traders who don’t backtest their trading systems.
The 200 SMA and 200 EMA, particularly the former tend to function as self-fulfilling prophecies when support/resistance occurs during a price test. This frequently occurs during retracements for mega-cap securities. This phenomenon is easily perceptible and easily exploited by even the most novice traders.
This doesn’t occur with the ALMA. Not enough traders are aware of the indicator’s existence for it to have self-fulfilling prophecies.
Now, this doesn’t mean you shouldn’t include the indicator in your trading system. Just don’t expect it operate as dynamic support/resistance too often.
Backtesting the ALMA. The ALMA vs. the EMA vs. the SMA.
The sky’s the limit for an astute backtester with the ALMA indicator in their repertoire.
A system’s max drawdown and the severity of the average losing position is oftentimes diminished when substituting an EMA or SMA for an ALMA.
However, this usually results in a lower net-profit achieved for the system. Remember, ALMA hugs price movement closers than the EMA and SMA; therefore, prices are likely to cross the ALMA frequently and more buy/sell signals will generate.
In addition, more trades are likely to execute and the system will achieve a lower win-rate.
Let’s runs some backtests.
We are going to backtest a simple price/moving average crossover system for the 200 day ALMA, the 200 day EMA, and the 200 day SMA. We’ll backtest each moving average in isolation.
When prices crossover the moving average a long position will execute.
Conversely, when prices cross under a moving average a short position will execute.
All backtests will run on $SPX, which is the S&P 500 Index.
Figure 1.3 ALMA Backtest Data
Performance test results for the ALMA.
Figure 1.4 EMA Indicator Backtest
Performance test results for the EMA.
Figure 1.5 SMA Indicator Backtests
I know what you’re thinking.
“The EMA has the highest net-profit AND the highest win-rate!”.
“Look at the max drawdown!”
The max drawdown is ~64%! That’s better than the SMA, but such high drawdown is generally intolerable.
For those of you unfamiliar, max drawdown reflects the greatest percentage loss our portfolio experienced before reaching all time highs again.
Therefore, our portfolio was down, at most, by ~28% with the ALMA system, ~64% with the EMA system, and ~88% (yuck) with the SMA system.
In this particular circumstance, we should consider the max drawdown for each system as testament for how close each moving average trails price movement.
Let’s rank the results by performance.
Now, evaluating these three data points does not constitute rigorous statistical analysis. There’s numerous other statistical pieces to account for.
For the sake of simplicity, we’ll limit our evaluation to Net-Profit, Win-Rate, and Max Drawdown.
Surprisingly, the EMA came out on top for Net-Profit and Win-rate; however, one might argue the max drawdown renders the system unusable. We won’t discuss personal preferences in this article!
The ALMA won the Max Drawdown contest, but came in third for total net-profit – just 10% less than the SMA.
The SMA flopped in this competition. Our portfolio was down approximately 88% at one-point before reaching all time highs. Even if you could stomach such extreme losses, there’s still not much going for the SMA in this competition. With such heavy losses we would like to see an exceptional net-profit, however the SMA almost placed third in the net-profit category.
Practical Use – Straight Talk
The ALMA indicator is an exceptionally useful component of a refined trading system. If you’re struggling with large losing positions or high drawdown with your strategy/system and are using a moving average other than ALMA, you might consider substituting the moving average for the ALMA.
Test it first! Don’t make the switch and subsequently trade it!
To be fair, it might be difficult for a non-backtester to confirm that the ALMA will work better for their system than the EMA or SMA. The ALMA doesn’t have self-fulfilling properties and support/resistance is less likely to occur when prices test the indicator.
A backtester will likely find the ALMA useful for decreasing the magnitude of the average losing position.
When a trend’s hot, ALMA will keep you in it, and get you out at the first sign of trouble.
However, this luxury comes at an expense – whipsaws.
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