Ulcer Index

Introduction

If there’s anything the stock industry is known for it’s the risks which there are a lot of and if you’re not careful then it’s only a matter of time until you get your hands burnt.

Circumventing them or basically doing anything about them is something that you’ll find on a lot of traders’ minds with them adopting every manner of tool or strategy to mitigate them.

But what if there was a tool that could reasonably measure the risk and allow you to make more informed decisions about when to enter or exit a trade?

Well it turns out there is one and that’s the Ulcer Index which we’ll be looking at below.

What is Ulcer Index?

The name Ulcer can be quite a strange name to have for an indicator but if you know the intent behind its creation then it may not sound so strange then.

Byron McCann and Peter Marin are the founders behind this indicator’s development which occurred around 1987 largely so that mutual funds could be analyzed.

However they first introduced it within their 1989 book which they called “The Investor’s Guide to Fidelity Funds.”

The indicator only looks at the downside risk and not the overall volatility whereas you’ll find that other volatility measures such as the standard deviation tend to treat down and up movement equally.

But usually you won’t find many traders minding upward movement since it’s usually the downward that leads to all those stomach ulcers and stress.

And now you know why it was named such.

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The Purpose of Ulcer Index

So the Ulcer Index is basically a technical indicator that can measure the downside risk regarding both the duration and depth of those price declines.

The index just rises in value once a price moves further away from its recent high and falls if the price then rises to a new high.

The indicator is typically calculated over a span of 14 days or periods with the Ulcer Index showing that percentage drawdown that a trader could anticipate from the high across the period.

So the higher the value of that Ulcer Index, then the longer it can take for the stock in question to reach back to its former high.

Simply put it’s designed as this single measure of volatility but only towards the downside that is.

How is Ulcer Index Calculated?

No matter where you’re trading from if the platform supports the indicator then you can be sure that it will automatically do all those calculations for you so you don’t really need to learn how to do all of it yourself.

But if you happen to be more of a curious type of trader where you just have to know all the underlying details behind those calculations then look no further as we’ll be looking at that here.

If you’re not though then you could just skip ahead.

Ulcer Index Calculation Steps

So there are three steps that you’ll have to complete if you are to calculate the Ulcer Index yourself and these are finding the percentage drawdown, the squared average and the Ulcer Index.

But if you want to find all of them out then you’ll need to know their formula first so here they are:

• Percentage Drawdown = [(Close – 14-period High Close)/14-period High Close] x 100
• Squared Average = (14-period Sum of Percentage Drawdown Squared)/14 
• Ulcer Index = Square Root of Squared Average

The price high thats used within the Ulcer Index calculation is usually determined by just adjusting that look-back period.

A 14 day Ulcer Index for example can measure those declines off that highest point within the last 14 days.

A 50 day Ulcer Index consequently measures the decline of the 50 day high.

A longer look back period would therefore provide investors with a better and more accurate representation of those long term price declines that they could face whereas a shorter look back period would offer traders with this gauge of the latest volatility.

Key Characteristics of Ulcer Index

So based on what we have explained so far about the indicator the key characteristics or components of it would have to be the Percentage Drawdown and the Squared Average and the look back period as finding all those is integral to completing that calculation.

How to Use Ulcer Index in Trading

Knowing about the indicator is one thing and actively trading with it is another and getting a hang of both is vital if you are to use the indicator to its utmost potential.

Identifying Risk Levels

The first and maybe the most obvious use case that it has to offer would have to be identifying risk levels associated with the stock you’re currently trading in.

Knowing those can be incredibly useful as that way you have some idea of where the investment currently stands in relation to its earlier performance.

Risk Management Strategies

Another obvious use of this indicator is to manage your risks with the strategies you’re undertaking or see how well they’re faring basically.

So in a way what you could do is to set up some stop loss orders with this indicator in that once the price reaches a certain point and the index shows an increasing value then you can trigger a sell order to stop your investment from dropping further in value.

Comparing Investments

Another thing you can do is to compare investments and see which investment’s downside risk is higher or lower and then pick one that better suits what you’re looking for

But a lot of the time finding an investment like that isnt easy and even if you do there’s no guarantee that it would stay that way as that risk just like the volatility within the landscape may fluctuate.

Combining Ulcer Index with Other Indicators

Sometimes using the Ulcer Index on its own may not be enough and you might be looking for some additional confirmation so that you know your trading decisions are reliable in which case there are plenty of indicators out there for you to combine the Ulcer Index with.

For example you could use that simple moving average as applying it could show you what stocks or funds tend to have less volatility overall.

Ulcer Index Strategies for Different Trading Styles

But what about all those trading styles that you see traders using like day, swing, and long term trading?

How can the Ulcer Index relate to those styles now?

You already know how it can be used to trade generally speaking but what can day or swing traders do to make the most use out of this indicator?

Let’s find out.

Day Trading with Ulcer Index

As a day trader your focus on making profits generally extends to the short term so maybe the default lookback period of the Ulcer Index may not be suitable to your style.

But do note that when you lower the period you’re also increasing the volatility that the indicator detects itself.

Swing Trading with Ulcer Index

As a swing trader your focus would likely be medium to long term profitability so like with day traders you can always adjust the lookback period to your liking so that the indicator better reflects your trading style.

Long-Term Investing with Ulcer Index

As for the long term traders, since your focus would be on the long term you should change the time frames accordingly to your advantage.

At least with the longer lookback period you’re getting a more reliable representation of those long term price declines that you may have to face.

Advantages and Limitations of Ulcer Index

Knowing both the advantages and the disadvantages of the Ulcer Index or rather any index for that matter will do you much good as that way you’re making the most out of your trading by mitigating those limitations and working around the pros.

Benefits of Using Ulcer Index

So the pros are that it can evaluate returns  all while assessing risks and providing a complete picture of how portfolios have been performing.

Then there’s also how losses are recognized as this psychological impact left on investors which is an aspect thats especially relevant to those possessing long term investment horizons.

It assists investors with the pinpointing of possibly overly volatile and high risk investments for their portfolios and this can aid them in enabling more enlightened choices.

Limitations of Ulcer Index

As for those limitations well there’s how it predominantly tailors to a long orientation which may not align that well with every type of investment strategy.

So when it comes to short term activities its effectiveness is lowered since it may lag behind swift market shifts.

Conclusion

By focusing on those downside risks the Ulcer Index is proven to be a well suited indicator for long term traders and even medium traders as it gives them a way to compute risk adjusted returns and thereby find the securities that would be the best to invest in.