The Ulcer Index was created by two Americans, Peter Martin, and Byron McCann, and first published in 1987 in their book “The Investor’s Guide to Fidelity Funds.”
Initially, this tool was dedicated to using mutual funds. Indeed, given that it aims to highlight only the downside risk of financial assets, it was well suited to follow the market as a whole.
Nevertheless, little by little, the Ulcer Index won the hearts of other investors by gradually entering their technical analysis toolbox. For many, it offers a better understanding than conventional mathematical tools for risk analysis, like the standard deviation.
What is the Ulcer Index indicator?
According to the author, it is the downside risk that makes traders stressful, not the upside. The index, therefore, aims to focus on this, exclusively analyzing bearish volatility and assessing the strength of a bearish retracement compared to the recent high points of an asset.
The index provides a measure of financial asset by comparing the highest point reached in recent sessions with the current price. It is generally calculated for 14 days, and its calculation method is as follows:
1st step: we calculate the retracement from the high point over a given period. The calculation is made for all the data in the series.
2nd step: we calculate the Ulcer Index.
- 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 author recommended using it on weekly periods; however, it turned out that the Ulcer Index can also be used in the daily data.
How to use the Ulcer Index indicator?
Generally, when the price of an asset goes up, the index goes down, and when the price goes down, the level of the index goes up. In the case of regular and relatively long-term trend, the index naturally tends towards 0. The example of the USD/CAD chart below illustrates the behavior of the Ulcer Index well. We can see that it skyrockets as soon as the prices start a correction and that it gradually returns to 0, as soon as a somewhat long upward trend takes place.
The main idea behind the Ulcer Index is that it is not like any classic technical analysis indicator. It is there to measure downward volatility and alert the trade when the level of “stress” reaches. If the value of index is above 5.0, it is considered as a risk of reversal. Therefore, it can be better to close the position when the index value rises above 5.0.
In the light of its historical stress peaks, it will provide information on the current situation, making it possible to highlight areas where the assets are oversold. The index is not limited to the rise. However, we will not focus on an absolute value, but we can compare behavior in the past to conclude the extremes of nervous sellers that can affect a financial asset.
Another use will be the comparison of the behavior of several values, to assess their relative risk. In the examples below, we have displayed two actions from USD/CHF and USD/CAD over 5 years in a weekly period. Below the price chart, we showed the Ulcer Index for 14 weeks with a moving average to observe the index’s smoothed trends.
We can see that the main trends of both the pairs are broadly comparable. Not surprisingly, the two currency pairs have similar USD in common. However, observing the Ulcer Index over 14 weeks sheds exciting light on the level of stress that an investment in these two pairs can generate. From the above two charts, we can clearly see that the USD/CAD pair seems better to invest than the USD/CHF. You can see the peaks in Ulcer Index that reflect more trading activity in the pair.
Ulcer Index trading strategy
We are going to discuss a simple trading strategy based on Ulcer Index value 0 and 5.
Ulcer Index buy strategy
- Consider a downtrend running over a long period.
- You can buy an asset if the index value reaches near zero (not greater than 1.50).
- Stop-loss can be placed around the swing low area.
- We may consider closing the position when the index value goes beyond 5.0.
Ulcer Index sell strategy
- Consider an uptrend running over a long period.
- You can sell an asset if the index value reaches near zero (not greater than 1.50).
- Stop-loss can be placed around the swing high area.
- We may consider closing the position when the index value goes beyond 5.0
Ulcer Index conclusion
The Ulcer index is not a conventional technical indicator that gives buy and sell signals or interpret the market phases. Instead, it is an indicator primarily used for managing the trades that can tell you if there is a chance of retracement.
I would prefer to use the majority of technical indicators such as the Ulcer Index on the 1-hour charts and above. I tend to find that these charts contain less market noise than the lower time frames and thus give more reliable signals for my forex trading strategies. This also means that I spend less time staring at charts and can also set alert notifications to let me know when price has reached certain levels or a particular indicator value has been reached.
The Ulcer Index is just one indicator amongst thousands. I would not build a trading system alone, but rather combine with other technical indicators such as moving averages, Parabolic SAR, Stochastic Oscillator, RSI, ADX and price action analysis.
Of course, every trading system will generate false signals which is why money management is so important. I would personally be implementing sensible money management and only take traders that give me a favorable risk to reward ratio, ideally of at least 1:3. This means that one losing trade does not wipe out consecutive winners.
The methods of implementing the Ulcer Index into a trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.
Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.
If you would like to practice trading with the Ulcer Index, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.