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
Based on closing prices, the Ulcer Index measures volatility based on price depreciation from its high over a specific look-back period. The index is zero if prices close higher each period. This means there is no downside risk because prices are steadily rising. Prices, of course, do not steadily rise, so there will be declines along the way. Using a default setting of 14 periods, the Ulcer Index reflects the expected percentage drawdown over this period.
The following comes from Peter G. Martin himself:
“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.”
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.
The Ulcer Index measures risk by focusing on drawdowns represented by price declines. This means it is best suited for long-only investors or traders. The index hovers near zero when prices regularly record higher highs and advance. The index rises when prices move lower and extend from their recent high. Keep in mind that the Ulcer Index is not exactly a typcial forex indicator per se. It is more of a measure of downside risk that can be used to compute risk-adjusted returns.
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