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What Is Ulcer Index And How to Interpret It

01 Sep 2023

Introduction:

Before trading or investing in the stock market, the first thing is to analyse the risk-return potential for a stock. You can do it through various technical indicators. They help in assessing the historical behaviour of shares and predict future price movements. As a trader, you can also use them to gain insights into the market psychology and determine the maximum profit or loss you can incur in a trade.

This article discusses a popular technical indicator – the Ulcer Index (UI). Developed by Peter Marin in 1989, this technical indicator is based on stomach ulcer disease, which happens when a thick layer of mucus is formed due to a damaged stomach lining.

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What is the Ulcer Index (UI)?

The ulcer index is a technical indicator that measures volatility in a stock. It helps traders like you know the maximum loss or profit in a trade and determine suitable entry and exit points. Peter Marin and Byron McCann introduced this concept in 1987 in their book “The Investor’s Guide to Fidelity Funds” to analyze mutual funds.

The Ulcer Index primarily measures the downside risk of a stock. It is the maximum potential for a decline in a stock’s value under volatile market conditions. As an investor, you buy a stock expecting an upsurge in its price, but the only risk you face is the downside risk.

The ulcer index gives you an idea of the maximum drawdown you can expect during a specified trading window. You don’t mind the upward surge in price, but the downside risk can cause stomach stress or ulcers, as the name of the indicator suggests.

How to calculate the Ulcer Index?

Calculating the ulcer index helps determine the volatility in a stock over a specified period. If the stock price keeps rising or stays steady during a trading period, the value of the ulcer index remains ‘zero’. By default, a period of 14 trading days is considered for calculating the value of the ulcer index. The value of the ulcer index is expressed as a percentage.

You can calculate the UI in three steps:

Step 1 – Derive the percentage drawdown by subtracting the highest closing price during the trading period from the current closing price and then, dividing the result with the former before multiplying the whole with 100

Percentage Drawdown = [(Current closing price – 14-day high closing price) / 14-day high closing price] x 100

Step 2 – Calculate the squared average for the trading period by dividing the 14-day squared sum of the percentage drawdown by 14

Squared Average = (14-day squared sum of percentage drawdown) / 14

Step 3 – Finally, evaluate the value of the UI as the square root of the squared average

Ulcer Index (UI) = (Squared Average) ^ ½

The value of the ulcer index increases as the stock price moves down from the current point before rising again. The higher the value of the ulcer index, the longer a share will take to bounce back from its lowest point.

Interpreting Ulcer Index

As mentioned, you can use the ulcer index to determine the downward risk associated with a share before entering a trade. For example, if the value of the ulcer index for a stock is 5%, a stock can move a maximum of 5% downward from the current point during the 14-day trading period.

Thus, you can take the help of the ulcer index to select stocks that cater to your risk appetite. If you have the ‘stomach’ to digest high risk, you can invest in stocks with higher UI value and vice-versa.

To use the UI indicator for the technical analysis of a stock, you need first to check if your charting platform has a built-in feature for the UI. It’s because platforms like MT4 doesn’t have pre-installed ulcer index indicator. In case your charting platform doesn’t have a built-in UI indicator, you can download and install it directly.

Then, you need to go to the “Indicator Settings” and set the trading period for applying the UI indicator. By default, the period is fixed as 14 days, but you can change it per your investment strategy.

The bottom line

The Ulcer Index is a popular technical indicator that lets you know the maximum downside risk before entering a trade. However, it’s worth noting that this indicator is unsuitable for all investors. It is useful mainly for swing traders with an investment horizon of around 10 to 15 days.

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