Last Updated on July 29, 2022 by Oddmund Groette
Risk management is a very important aspect of trading. One of the most useful indicators for assessing risks is the Ulcer Index. What is the index, and what does it tell you?
The Ulcer Index (UI) is a volatility indicator that measures downside risk in terms of both the depth and duration of price declines. It considers the highest closing price over a given period, typically 14 days, and shows the percentage drawdown a trader can expect from the high over that period.
What is the ulcer index?
The Ulcer Index (UI) is a volatility indicator that measures downside risk in terms of both the depth and duration of price declines. It considers the highest closing price over a given period, typically 14 days, and shows the percentage drawdown a trader can expect from the high over that period. Thus, it increases in value as the price moves farther away from a recent high and falls as the price rises to new highs. Also, the greater the value of the index, the longer it takes for a stock to get back to the former high.
Simply stated, the Ulcer Index is a volatility indicator that helps traders and analysts determine risks while trading. However, the index measures volatility only on the downside. First introduced in 1989, the index was designed for assessing mutual funds, which is why the index is primarily based on downside risk — the potential of a security to decline in value due to changing market conditions.
Since mutual funds are created to make money for the investors by only going up in value, the only risks that they face are the downside. The indicator was named Ulcer Index to give investors a clear view of the downside risks so they know if they could “stomach” the investment. Many consider the index superior to other ways of calculating risk, such as standard deviation.
What is the Ulcer Index formula?
The indicator involves a 3-step calculation, and the formulae for the three steps are given as follows:
Percentage Drawdown = [(Close – 14-period Highest Close)/14-period Highest Close] x 100
Step 2: Getting the Squared Average
Step 3: Getting the Ulcer Index
Note that the price high used in the Ulcer Index calculation is determined by adjusting the look-back period. Thus, a 14-day Ulcer Index measures the decline from the highest close in the past 14 days, while a 50-day Ulcer Index measures the decline from the 50-day highest close. In essence, a longer look-back period offers a more accurate representation of the long-term price declines they may face. Conversely, a shorter-term look-back period shows potential short-term volatility.
Who invented the ulcer index?
The Ulcer Index was developed by Peter Martin and Byron McCann for analyzing mutual funds. The indicator was created in 1987, but Martin and McCann first published it in their 1989 book, The Investor’s Guide to Fidelity Funds.
The indicator was designed to measure only the downside risk, not the overall volatility that other volatility indicators such as the standard deviation measure. Martin’s and McCann’s intention was to create a way to measure the downside risk, which causes stress and stomach ulcers, as the index’s name suggests.
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- Sortino Ratio – what is it and how do you use it?
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What does the Ulcer Index tell you?
Here is what the inventor had to say about the Ulcer Index:
Ulcer Index measures the depth and duration of percentage drawdowns in price from earlier highs. The greater a drawdown in value, and the longer it takes to recover to earlier highs, the higher the UI. Technically, it is the square root of the mean of the squared percentage drawdowns in value. The squaring effect penalizes large drawdowns proportionately more than small drawdowns.
Most analysts recommend using the index as a measure of risk in any situation where the standard deviation (SD) can be used. As a statistical measure, you can compare Ulcer Index values of different assets to determine relative risk, and the index tends to work well with weekly data.
You can also chart the Ulcer Index over time and use it as a kind of technical analysis indicator to show stocks that are going into an ulcer-forming territory. The value you designate as your ulcer-forming territory is up to you.