The Ulcer Index |Formula, Performance and Indicator

Risk management is an essential aspect of trading. One of the most valuable 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 return to the former high.

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 to 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:

Step 1: Getting the Percentage Drawdown

Percentage Drawdown = [(Close – 14-period Highest Close)/14-period Highest Close] x 100

Step 2: Getting the Squared Average

Squared Average = (14-period Sum of Squared Percentage Drawdown)/14

Step 3: Getting the Ulcer Index

Ulcer Index = Square Root of Squared Average

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. 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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