After students of technical analysis master some of the foundational indicators, they might want to tackle some of the lesser-known and discussed technical indicators.
Here we look at absolute breadth and the ulcer indexes.
Major financial newspapers and magazines and investment television programs often refer to market breadth as the difference between advancing and declining issues. It's just as easy to understand that the absolute breadth indicator calculates the difference between advancing and declining issues and then indicates this value for each bar on the chart. Therefore, a chartist can look at the absolute breadth index and determine the activity level of the market.
One common form of describing the parameters that make up the index is as follows: advancing issues are those that close above their opening price that day and conversely, declining issues close below their opening price of the day. There are other data that can be inserted to provide other looks to the idea of advancing/declining issues; however, these are the most common parameters. Please note that whatever data is used for the advancing issues, the same data must be used for the declining issues.
If for example the market is rallying but more issues are declining than advancing, we could then determine that the rally is somewhat unstable as many issues on the exchange are falling off and not advancing with the few making all the noise.
If a technician sees high values indicating on the chart, the assumption is that the market is moving primarily in one direction. On the other hand, the market is showing no significant direction at all if the values indicated are low. The absolute-breadth index can also be an early indicator of future trend changes in the market and offer signals either to confirm or warn against the weakness or strength of the market as a whole.
Much of what we see in this chart of SunMicrosystems (SUNW) from June 2002 to March 2003 when compared to the broad S&P 500 Index is a declining market with SUNW appearing to be treading water in a horizontal band. The absolute breadth index has lost more than 100 points since the start of the year, representing a slow-moving downtrend.
Developed by Norman G. Fosback, the absolute breadth index (ABI) has been referred to as market momentum indicator. It simply shows market activity. In his book, "Stock Market Logic", Fosback talks about "historically high values that lead to higher prices three to twelve month out". Fosback also found that a highly reliable variation of the absolute breadth index is to divide the weekly ABI by the total number of issues or securities traded. A 10-week average of this value is then calculated. The readings above 40% are very bullish and readings below 15% are bearish. (For more insight, see Market Breadth: A Directory Of Internal Indicators.)
The Ulcer Index
Developed by Peter G. Martin and Byron B. McCann and described in detail in their book, "The Investor's Guide To Fidelity Funds" (1989), the ulcer index is a very effective risk indicator. Risk means many things to many people but it is inherent to investing.
Peter Martin and Byron McCann, once stated, "the higher an investment's ulcer index, the more likely investing in it will cause ulcers or sleepless nights."
Here's what Gary Elsner, Ph.D., the editor of the mutual-fund timing newsletter Achieve Profits writes:
|"The standard deviation is a good measure of volatility, since it measures the amount of variation around the average and is probably the most widely used measure of financial risk. But the standard deviation has two weaknesses for financial instruments. First, it measures the variation from the average in both the up (good) direction as well as the down (bad) direction. Second, the standard deviation does not distinguish between short or long sequences of losses. Investors are only concerned about downside risk (or the potential for losses), whereas upside changes or rapid increases in value create profits. In contrast to the standard deviation, the ulcer index has none of the aforementioned weaknesses since it calculates retracement, the tendency for values to fall from previous highs, by measuring the depth of the drop and the time that it takes the performance measure to recover to the original level."|
You can see in the chart of Exxon Mobil from February 2002 to February 2003, the spike of the ulcer index as the market drops in the third week of July. The balance of the chart shows smaller moves above the 'safe line' with the price of Exxon Mobil stock dropping gradually over a period of a number of weeks. It is safe to say that the ulcer index is a good indicator of short-term performance or non-performance. The ulcer index measures change from the previous high of an issue and not from an average price of an issue over a period of time.
Elsner goes on to say, "The measurement includes every drop in performance in the period being studied. Funds or trading systems with high ulcer-index readings should be avoided unless they have such exceptionally high returns that the risks are justified."
The Bottom Line
Both of these indicators have a place in the overall of any savvy trader, and applying these indicators to your charts may help you determine the effectiveness for your own individual investing philosophies and programs.
Remember it's your money - invest it wisely.
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