Last Updated on July 19, 2023
The Ulcer Index (UI) is a popular indicator used by investors to measure downside risk. In the article below, we look closer at the Ulcer Index and Martin Ratio, how to calculate UI, how the index can help in trading, as well as its advantages and disadvantages.
We also examine what differentiates the UI indicator from the Standard Deviation and how to incorporate the former into your trading routine.
What is the Ulcer Index or Martin Ratio?
The Ulcer Index is a technical indicator that gauges downside risk. The index’s value appreciates when the security price tumbles and depreciates when the price hits new highs.
The UI is usually measured over a 14-day period, with the indicator suggesting the percentage drawdown investors can expect relative to the security’s high.
Peter Martin and Byron McCann originally developed the Ulcer Index in 1987 to focus on mutual funds. As stated in Marin’s and McCann’s book ‘The Investor’s Guide to Fidelity Funds’, the UI mainly evaluates downside risks and focuses less on overall volatility.
Money managers aim to generate profits by increasing the value of the assets under management. The main risk in such activities is a drawdown. The Ulcer Index helps measure the drawdown investors can expect for a particular security. This makes it different from other risk-measuring indicators like standard deviation (SD), which puts equal weight on up and down price movements.
As such, managing risk using the UI can lead to very different results, particularly when reviewing investment strategies that aim to prevent declines in portfolio value.
Martin also developed the Ulcer Performance Index (UPI), also known as the Martin Ratio, which focuses on downside volatility, causing price drawdowns. UPI is similar to the Sharpe Ratio but uses the Ulcer Index instead of standard deviation as a risk measure. Securities with the highest UPI are those with the highest risk-adjusted returns.
Calculating the Ulcer Index
As noted above, the Ulcer Index gauges volatility based on how much the security’s price declined from its high over a specific timeframe. Below is the formula to calculate the Ulcer Index using a typical setting of a 14-day period.
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
To determine which price high to use, investors have to adjust the look-back period. As such, a 14-day UI measures how much the security’s price deviated from its peak in the previous 14 days. Investors analyze longer look-back periods, such as 50 days, when they want to check for potential price declines in the long run. On the other hand, shorter periods allow investors to measure short-term volatility.
The UI calculates both the amount and the time period for a percentage decline relative to recent highs. Because of this, a larger drawdown means that it would take longer for the price to rebound and recover its previous highs, which is reflected in the higher value of the Ulcer Index.
As opposed to standard deviation, UI’s calculated value remains the same over a broad range of time intervals between data points. Investors look at both daily and weekly price data, though intervals longer than a week can lead to missing notable intra-period drawdown-and-recovery developments. Therefore, many advise against assessing price data in long intervals such as quarters.
When Can the Ulcer Index Help?
The Ulcer Index’s key benefit lies in the indicator’s nature – evaluating the depth and length of downside risk. Most analysts and experienced traders say that UI can serve as a risk gauge in any situation where the SD can be used.
It’s also important to note that the Ulcer Index isn’t an ideal technical indicator to use in day trading. In contrast, it is very useful for long-term investing because the index hovers around 0 when security prices continue to advance and reach new record highs.
Investors and traders shouldn’t treat the UI as a typical technical indicator but rather as a powerful measure of downside risk designed to calculate risk-adjusted returns.
One of the index’s main use cases is to weed out extremely volatile securities. For example, you can apply the UI in the search for S&P 600 stocks to disregard the highly-volatile stocks in the index.
Advantages
The primary advantage of the Ulcer Index compared to other indicators is that it completely focuses on measuring downside risks. Because it represents the decline in security prices, it is particularly useful for long-term investors.
Additionally, it can also be used for comparing volatility between multiple securities. A low average UI suggests a smaller drawdown risk, while a higher average UI usually means higher risk. Investors sometimes apply a moving average (MA) to the UI to identify securities with lower overall volatility.
If the Ulcer Index shows unusual spikes, it could mean that the security is facing extreme downside risk, meaning that the investors should avoid holding a long position in these securities.
A clear disadvantage of the Ulcer Index is that it is only suitable for price actions that are moving higher. As with any other trading indicator, the UI is best used with other indicators.
Ulcer Index vs. Standard Deviation
The Ulcer Index is typically used as an alternative to the Standard Deviation (SD), mainly because the latter measures both upside and downside volatility, while UI focuses solely on downside risks.
Because upside volatility is generally good for investors, the UI doesn’t account for it.
While both have similar use cases, utilizing the UI instead of SD can yield very different outcomes, particularly with dynamic asset allocation, market timing, and other portfolio management strategies.
The main idea behind the UI is to serve as a reference data point that provides significantly more information about downside risks than the standard deviation, which is often viewed as a proxy for risk.
Furthermore, UI informs investors about both the depth and length of a drawdown. This is particularly important because a shallow drawdown that persists over a long time period can cause as much damage as a steep, shorter drawdown.
Another key difference between the UI and SD is the way they are calculated. SD is calculated through several steps, including determining the security’s average closing price, finding the deviation for each period followed by square deviations, finding the sum of squares and variance, and finally, calculating the square root of the variance. Calculating the UI is more straightforward.
Using the Ulcer Index in Trading
As already mentioned, the Ulcer Index is used to detect appealing trading opportunities, though it may take some time to get used to the indicator. Analysts say the UI can be utilized in any situation where the standard deviation is typically used.
As said earlier, the UI is usually measured over a 14-day period. Hence you should check whether the default period is set at 14.
Once applied over a chart, the Ulcer Index typically uses two colors – green and red – as well as a horizontal dotted line that acts as the signal one. It is important to note that UI is best suited when the market is moving upwards.
As the chart above shows, the UI moved higher when Berkshire Hathaway shares were falling and vice versa. The green and red circles on the chart represent crossover periods. If the price hits a new high each period, the value of the UI is 0. This suggests that there are no downside risks because the price appreciates in a steady manner.
Final Thoughts
The Ulcer Index measures downside risk by evaluating drawdowns represented by price declines. The value of the Ulcer Index increases when security prices decline and move away from their recent peaks. Similarly, the index is near 0 when prices keep rising and hitting new highs.
The index best suits long-term investors and assets that move upwards. Many technical experts advise against using the UI in day trading.
