Introduction
The Ulcer Index (UI) is an indicator that calculates downside risk in terms of price declines both in magnitude and length. The index increases in value as the market moves further away from a recent peak and falls to new lows as the price drops.
The indicator is typically measured over 14 days, with the Ulcer Index showing the percentage drawdown that a trader may expect from the high during that time.
The higher the Ulcer Index value, the longer it takes for a stock to return to its former high point. Simply stated, it is only designed at the downside as one measure of volatility.
Understanding UI
In 1987, the Ulcer Index was created for the study of mutual funds by Peter Marin and Byron McCann. Marin and McCann initially published it in their book, The Investor's Guide to Fidelity Funds (1989).
The metric looks only at risk of a downside, not the uncertainty overall. Certain parameters of volatility, such as standard deviation, view up and down movement equally, but usually, an investor doesn't mind upward movement. As the name of the index implies, it's the downside that induces discomfort and stomach ulcer.
Formula
The indicator is calculated in three steps:
*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*
By adjusting the look-back period, the appropriate price high used in calculating the Ulcer Index is determined. A 14-day Ulcer Index test fell off the highest level in the past 14 days. An indicator of a 50-day Ulcer Index declines off the 50-day mark.
A longer look-back duration offers investors a more reliable picture of the price losses they may face in the long term. A shorter-term look-back window provides a gage of recent uncertainty for traders.
