HOLLOW POINT TRADING
What Is the Ulcer Index?
Unlike standard volatility measures (like standard deviation) that treat upside and downside movement equally, the Ulcer Index focuses exclusively on downside risk. It measures the depth and duration of price drawdowns from recent peaks.
Specifically designed for long-term investors, a higher Ulcer Index indicates more significant "stress" or potential for "ulcers" caused by holding the asset through declines.
Why It Matters
- Risk Sensitivity: Captures the specific pain of losing money
- Recovery Time: Accounts for how long it takes to return to new highs
- Investor Psychology: More accurately reflects the emotional experience of drawdowns
How It's Calculated
The Ulcer Index is calculated over a specific period (usually 14 days) through three steps:
1. Percentage Drawdown: Calculate the percentage decline from the recent high.
2. Squared Average: Square each of those drawdown values and calculate their average.
3. Square Root: Take the square root of that average result.
Interpretation
Low UI Values
Indicator of "smooth" price action with shallow, short-lived drawdowns. Common in strong bull markets or stable assets.
High UI Values
Signals significant volatility characterized by deep price drops and long recovery periods. Typical of bear markets or highly speculative assets.
The Ulcer Performance Index (UPI)
Also known as the Martin Ratio, the UPI measures risk-adjusted return using the Ulcer Index as the risk component.
Rule of Thumb: A higher UPI is better, as it indicates a trader is earning more return per unit of "downside stress" taken.
UI vs. Standard Deviation
| Feature | Standard Deviation | Ulcer Index |
|---|---|---|
| Direction Focus | Both (Up & Down) | Downside Only |
| Risk Type | General Volatility | Pain of Loss |
| Best For | Options Pricing | Portfolio Allocation |
Key Takeaways
The Ulcer Index is a superior tool for understanding the true risk of an investment strategy because it ignores "good" upside volatility and focuses on the drawdowns that actually cause investor panic. Use it to compare assets and evaluate risk-adjusted performance.