The Ulcer Index attempts to measure the “stress” of holding a trade or investment by measuring price retracements.
The Ulcer Index is based on the notion that downward volatility is bad, but upward volatility is good.
Unlike standard deviation, the financial industry's benchmark way of measuring the risk of a stock, which equally weights both violent increases to the upside (upside volatility) and violent decreases to the downside (downside volatility), the Ulcer Index takes an arguably more enlightened approach that states that traders only care about the downside risk of a stock, not the upside risk (upside risk is good, it is equivalent to profits. . . if a trader is long stock, that is).
The chart of Intel stock below shows various elements of the Ulcer Index:
On the very left of the chart, Intel stock had a strong, sustained movement higher, marked by the long string of green, bullish candlesticks. Notice that the Ulcer Index remained flat, well below the safe level.
- Above safe level (>5): Many downward retracements, investment will cause the investor ulcers, stress, and/or difficult nights sleeping.
- Below safe level (<5): A moderate to low number of price retracements to the downside; relatively few ulcers, stress, and/or difficult nights sleeping.
A third of the chart from the left, there was a 14-day drawdown period; this drawdown period was seen with the sharp increase in the Ulcer Index. Once the price of Intel was making new highs past the drawdown period, the Ulcer Index fell.
The high price of Intel on the chart was marked by a large gap downward; the Ulcer reacted sharply to this drawdown, rising above the safe level.
Another use for the Ulcer Index is shown on the next page: Comparing Investments using the Ulcer Index.
Ulcer Index Investment Comparison
Finance theory states that “the greater the risk the greater the potential reward”. As stated previously, the Ulcer Index believes that it is only downside risk that is important to the risk-averse investor. Therefore, a comparison of stocks, mutual funds, commodities using the Ulcer Index might prove valuable.
A comparison of two stocks in the semiconducter sector is given below, Advanced Micro Devices (AMD) stock on the top and Intel (INTC) stock on the bottom along with their respective Ulcer Indexes:
Comparing Investments Using the Ulcer Index
AMD has a higher Ulcer Index than INTC, therefore, during the space of price information on the chart above, AMD would be viewed as the riskier alternative.
In order to justify investing in AMD as opposed to INTC, AMD potential rewards would vastly have to outweigh INTC potential rewards.
The real strength of the Ulcer Index is its focus on only downside risk. To illustrate, a stock gapping up 10% would affect the standard deviation calculation the same as a stock that gapped down 10%; however, if an investor was long stock, which a vast majority are, the gap up would be viewed with joy, while the gap down would be viewed with horror.
While standard deviation has its place and is still useful, the Ulcer Index focuses on downside risk rather than the simple standard deviation/variance calculation that calculates upside and downside risk together.
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