What is Ulcer Index (UI) & How to Interpret it ?

The first step in stock trading or investing is to determine if the stock's performance is good. This can be done by using a stock index.

An index measures the performance of certain stocks in the stock market by calculating their change over time. It can measure both the upward or downward movements that a stock might experience.

An index of stock values is based on the value of its underlying securities. The stock index is essentially an indicator of the performance and value of the underlying stocks. This can be understood by simply understanding that if shares in an index show an upward trend, then the stock index will also rise. However, if investors sell shares, the index will reflect losses.

What's the Ulcer index?

The Ulcer Index, a volatility indicator, helps traders and analysts to determine the best entry and exit points for trading. This indicator was introduced for the first time in 1989. It was originally designed to be used with mutual funds. The index is built on downside risk, which is the possibility that a security's value will decline due to changes in market conditions. Mutual funds were created to grow one's wealth by increasing its value. The only downside to mutual funds is their inability to reduce it. Investors can see the risks and "stomach" their investment by using the Ulcer Index indicator. Many consider the Ulcer Index indicator superior to standard deviation and other methods of calculating risk.

Ulcer Index Calculation

Calculating the Ulcer Index reflects volatility of security based on its price change over a period. If the closing price is higher, the index will remain at zero. Since prices continue to rise, there is no downside risk. However, this does not necessarily mean that prices will fall. The default period for calculation of the Ulcer index is 14 days.

The Ulcer Index's value increases as the price moves away from a recent drop and decreases as the price rises. The Ulcer Index's value will determine how long it takes for a security to recover to its previous high.

The indicator can be calculated in three steps

– Percentage Drawdown: Closing price minus highest closing price during the period of 14 days divided by the latter. Wholly multiplied with 100

– Squared Average: The squared sum, divided by 14, of the percentage drawdown over the 14-day period.

- The Ulcer Index: which is the square root for the squared average, is last

Interpretation

The Ulcer Index calculates both the percentage drawdown and the time period in which it takes to recover from the previous highs. The Ulcer Index is higher if a stock has a longer drawdown than it takes to recover from its original high point.

The Ulcer Index - The Advantages

The Ulcer Index has the advantage of focusing on the security's downward risks only.

Standard deviation is an example of this. A stock that shifts 10% because it has lower risk would have the same effect on the final numbers as one that shifts 10% up. The Ulcer Index helps to see that a gap up is a positive for investors, while a gap down can be disappointing. Standard deviation is simply a calculation of upside and downside risk. It does not emphasize the good or the bad, but simply shows variance.

You can also use the Ulcer index to scan securities that have high volatility. To search for stocks showing signs of an uptrend, a scan can be performed. Any stocks with high volatility will be removed from the final scan.

The Ulcer Performance Index has been added

Another tool to calculate risk-adjusted returns is the Sharpe Ratio. This is the total return less the risk-free return divided with the standard deviation. We have found that standard deviation is inferior to long-term investors. The Ulcer Performance Index, which uses the same formula, but is divided by the Ulcer Index, instead of standard deviation, was therefore created. This is how you can calculate the risk-adjusted return. The higher the Ulcer Performance Index, the better.

Conclusion

The Ulcer Index represents the fall in securities prices by focusing only on drawdown risks. It is therefore well-suited for traders and long-term investors. If the index is near zero, this means that the security is consistently measuring higher gap ups. The UI rises as the security's price drops. Although it is not an indicator, it can be used to help investors calculate risk-adjusted returns to find the best securities.