What Does Ulcer Index Mean?

The Ulcer Index (UI) is a technical indicator that measures downside risk in terms of both the depth and duration of price declines. The index increases in value as the price moves farther away from a recent high and falls as the price rises to new highs. The indicator is usually calculated over a 14-day period, with the Ulcer Index showing the percentage drawdown a trader can expect from the high over that period.

The greater the value of the Ulcer Index, the longer it takes for a stock to get back to the former high. Simply stated, it is designed as one measure of volatility only on the downside.

Understanding Ulcer Index (UI)

The Ulcer Index was developed by Peter Marin and Byron McCann in 1987 for analyzing mutual funds. Marin and McCann first published it in their 1989 book, The Investor’s Guide to Fidelity Funds. The indicator looks only at downside risk, not overall volatility. Other volatility measures, like standard deviation, treat up and down movement equally, but a trader typically does not mind upward movement; it is the downside that causes stress and stomach ulcers, as the index’s name suggests.

Calculating the Ulcer Index

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

Which price high is used in the Ulcer Index calculation is determined by adjusting the look-back period. A 14-day Ulcer Index measures declines off of the highest point in the past 14 days. A 50-day Ulcer Index measures declines off of the 50-day high. A longer look-back period provides investors with a more accurate representation of the long-term price declines they may face. A shorter-term look-back period provides traders with a gauge of recent volatility.

Using the Ulcer Index

Martin recommends the Ulcer Index as a measure of risk in various contexts where the standard deviation is usually used. The Ulcer Index can also be charted over time and used as a kind of technical analysis indicator, to show stocks going into ulcer-forming territory, or to compare volatility in different stocks.

Investors can use the Ulcer Index to compare different investment options. A lower average Ulcer Index means lower drawdown risk compared with an investment with a higher average UI. Applying a moving average to the Ulcer Index will show which stocks and funds have lower volatility overall.

Watching for spikes in the Ulcer Index that are beyond “normal” can also be used to indicate times of excessive downside risk, which investors may wish to avoid by exiting long positions.

Divergence vs. Convergence: An Overview

There are numerous trends and tools in the world of economics and finance. Some of them describe opposing forces, such as divergence and convergence. Divergence generally means two things are moving apart while convergence implies that two forces are moving together. In the world of economics, finance, and trading, divergence and convergence are terms used to describe the directional relationship of two trends, prices, or indicators. But as the general definitions imply, these two terms refer to how these relationships move. Divergence indicates that two trends move further away from each other while convergence indicates how they move closer together.

Divergence

When the value of an asset, indicator, or index moves, the related asset, indicator, or index moves in the other direction. This is what is referred to as divergence. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction.

Divergence can be either positive or negative. For example, positive divergence occurs when a stock is nearing a low but its indicators start to rally. This would be a sign of trend reversal, potentially opening up an entry opportunity for the trader. On the other hand, negative divergence happens when prices go higher while the indicator signals a new low.

When divergence does occur, it does not mean the price will reverse or that a reversal will occur soon. In fact, divergence can last a long time, so acting on it alone could be mean substantial losses if the price does not react as expected. Traders generally don’t exclusively rely on divergence in their trading activities. That’s because it doesn’t provide timely trade signals on its own. 

Convergence

The term convergence is the opposite of divergence. It is used to describe the phenomenon of the futures price and the cash price of the underlying commodity moving closer together over time. In most cases, traders refer to convergence as a way to describe the price action of a futures contract.

Theoretically, convergence happens because an efficient market won’t allow something to trade for two prices at the same time. The actual market value of a futures contract is lower than the contract price at issue because traders have to factor in the time value of the security. As the expiration date on the contract approaches, the premium on the time value shrinks, and the two prices converge.

If the prices did not converge, traders would take advantage of the price difference to make a quick profit. This would continue until prices converged. When prices don’t converge, there is an opportunity for arbitrage. Arbitrage is when an asset is bought and sold at the same time, in different markets, to take advantage of a temporary price difference. This situation takes advantage of inefficiencies in the market.

Key Differences

Technical traders are much more concerned with divergence than convergence, largely because convergence is assumed to occur in a normal market. Many technical indicators commonly use divergence as tools, primarily oscillators. They map out bands (both high and low ones) that occur between two extreme values. They then build trend indicators that flow within those boundaries.

Divergence is a phenomenon that is commonly interpreted to mean that a trend is weak or potentially unsustainable. Traders who employ technical analysis as part of their trading strategies use divergence to read the underlying momentum of an asset.

Convergence occurs when the price of an asset, indicator, or index moves in the same direction as a related asset, indicator, or index in technical analysis. For example, there is convergence when the Dow Jones Industrial Average (DJIA) shows gains at the same time that its accumulation/distribution line is increasing.

Exponential Moving Average vs. Simple Moving Average: An Overview

Exponential Moving Average (EMA) and Simple Moving Average (SMA) are similar in that they each measure trends. The two averages are also similar because they are interpreted in the same manner and are both commonly used by technical traders to smooth out price fluctuations.

There are some differences between the two measurements, however. The primary difference between an EMA and an SMA is the sensitivity each one shows to changes in the data used in its calculation.

SMA calculates the average of price data, while EMA gives more weight to current data. The newest price data will impact the moving average more, with older price data having a lesser impact.

More specifically, the exponential moving average gives a higher weighting to recent prices, while the simple moving average assigns equal weighting to all values.

Exponential Moving Average

Since EMAs place a higher weighting on recent data than on older data, they are more reactive to the latest price changes than SMAs are, which makes the results from EMAs more timely and explains why the EMA is the preferred average among many traders.

As shown in the example below, traders with a short-term perspective may not care about which average is used, since the difference between the two averages is usually a matter of mere cents. On the other hand, traders with a longer-term perspective should give more consideration to the average they use because the values can vary by a few dollars, which is enough of a price difference to ultimately prove influential on realized returns, especially when you are trading a large quantity of stock.

As with all technical indicators, there is no one type of average a trader can use to guarantee success.

Simple Moving Average

The SMA is the most common type of average used by technical analysts and is calculated by dividing the sum of a set of prices by the total number of prices found in the series. For example, a seven-period moving average can be calculated by adding the following seven prices together and dividing the result by seven (the result is also known as an arithmetic mean average).

Example
Given the following series of prices:
$10, $11, $12, $16, $17, $19, $20
The SMA calculation would look like this:
$10+$11+$12+$16+$17+$19+$20 = $105
7-period SMA = $105/7 = 15

What Is Relative Strength?

Relative strength is a strategy used in momentum investing and in identifying value stocks. It focuses on investing in stocks or other investments that have performed well relative to the market as a whole or to a relevant benchmark. For example, a relative strength investor might select technology companies that have outperformed the Nasdaq Composite Index, or stocks that are outperforming the S&P 500 index.

Technical analysts use an indicator known as the relative strength index (RSI) to generate overbought or oversold signals.

Understanding Relative Strength

While the goal of value investing is to buy low and sell high, the goal of relative strength investing is to buy high and sell even higher. As such, relative strength investors assume that the trends currently displayed by the market will continue for long enough to allow them to realize a positive return. Any sudden reversal to that trend will lead to negative results.

To identify investment candidates, relative strength investors begin by observing a benchmark such as the Nasdaq Composite Index. They will then look to see which companies within that market have outperformed their peers, either by rising more rapidly than their peers or by falling less rapidly than them.

Because relative strength investing assumes that present trends will continue into the future, it is most effective in stable periods with minimal disruption. By contrast, chaotic periods such as the 2007–2008 financial crisis can be dangerous for relative strength investors because they can lead to sharp reversals of investment trends. In those situations, investor psychology can suddenly reverse, with yesterday’s investment darlings suddenly being shunned.

Although momentum investing is often associated with individual stocks, it can also be applied to whole markets or industry sectors using index funds and exchange traded funds (ETFs). Similarly, investors can make relative strength investments in other asset classes, such as in real estate, using real estate investment trusts (REITs). More exotic instruments, such as commodity futures, options, and other derivative products, can also be used.

Real-World Example of Relative Strength

Harry is a relative strength investor who keeps a close eye on corporate bond prices and the S&P 500. His investment portfolio consists of an S&P 500 index fund and an ETF that tracks the corporate bond market. As a relative strength investor, he periodically increases his allocation toward whichever asset is outperforming at that time. In doing so, he hopes to benefit from the continuing trend of that asset’s outperformance, effectively buying high and selling higher.

In recent months, he has noticed that investors seem to be increasing their portfolio bond allocations at the expense of stocks. This inflow of money into the bond market has been raising bond prices and lowering yields.

Expecting this trend to continue, Harry responds by decreasing his investment in the S&P 500 and increasing his investment in the corporate bond ETF. He hopes to benefit from any ongoing outperformance of bonds relative to stocks.

Relative Strength Index (RSI)

Short-term and technical traders also look at relative strength. In technical analysis, the relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, “New Concepts in Technical Trading Systems.”

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.