While trading and investing in stocks, the first step is to measure if the stock is performing well. This is done through a stock index.
An index calculates change over a period of time and measures how certain stocks perform in the market. It measures both the upward and downward changes that a stock may experience.
A stock index bases its value in the value of underlying securities. Therefore, the stock index essentially reflects the performance of underlying stocks. The easiest way to understand this is that if the group of shares in the index are performing on an upward trend, the stock index will rise as well; however, if the investors are selling the shares, the index will depict losses.
What is the Ulcer Index?
The Ulcer Index is a volatility indicator that helps traders and analysts determine good entry and exit points while trading. The concept was first introduced in 1989 and was designed with a focus on mutual funds. That is why the index is primarily based on downside risk which is the potential of a security to decline in value due to changing market conditions. Since mutual funds are created to increase one’s money by only going up in value, the only risks that they face are a downside. The Ulcer Index indicator was named so to give investors a clear view of the downside risks so they could “stomach” the investment. The Ulcer Index indicator is considered superior by many in comparison to other ways of calculating risk such as standard deviation.
Ulcer Index Calculation
The Ulcer Index calculation reflects the volatility of a security depending on the depreciation of its price over a specific period. The index remains at zero if the prices are higher at closing. This implies that there is no downside risk since prices are rising in a consistent manner. It is important to note, however, that does not mean that there will be no reductions in price along the way. The Ulcer index calculation is done over a default period of 14 days.
The Ulcer Index increases in value as the price moves further away from a recent fall and decreases in value as the price rises again. Therefore, the greater the value of the Ulcer Index, the more time a security will need to bounce back to its former high.
The indicator is calculated in three steps:
– Percentage Drawdown : Closing Price minus the highest closing price in the 14 day period divided by the latter, wholly multiplied by 100
– Squared Average : The squared sum of the percentage drawdown in the 14 day period divided by 14
– Finally, the Ulcer Index is the square root of the squared average
The Ulcer Index calculates the amount as well as the time period for a percentage drawdown in comparison to the previous highs. Hence, the worse the drawdown, the more time it would take for a stock to recover and return to the original high point, therefore the higher the Ulcer Index.
Advantages of the Ulcer Index
An advantage to the use of the Ulcer Index is to focus solely on the downward risks faced by a security.
For example, with standard deviation, a stock that shifted by 10% due to downward risk would impact the final figures in the same manner as a stock that shifted 10% up. However, the Ulcer Index brings into perspective that a gap up would be an obvious positive for the investor while a gap down would be disappointing. Hence standard deviation simply calculates upside and downside risk together not emphasising the good and the bad while simply showing variance.
The Ulcer index can also be used to sort and scan those securities with very high volatility. A scan can be run to search specifically for those stocks that are showing indications of an uptrend. The final scan will remove any stocks that show high volatility.
Addition of the Ulcer Performance Index
The Sharpe Ratio is another tool used to calculate risk-adjusted return which is the total return minus the risk-free return divided by the standard deviation. However, we have established that long-term investors find standard deviation to be inferior. Hence, the Ulcer Performance Index was created which is the same formula however, it is divided by the Ulcer Index instead of standard deviation. This accounts for the risk-adjusted return, the higher the Ulcer Performance Index the better.
By focusing solely on the drawdown risks, the Ulcer Index is a representation of the decline in prices of securities. This would mean that it is suited well for long-term investors and traders. When the index is at or near zero, it means the security is steadily measuring higher gap ups. As the price of the security drops, the UI increases. It may not be an indicator in and of itself however, it allows investors to calculate risk-adjusted returns and therefore find the best securities to invest in.