DEFINITION of 'Entropy'

Entropy is a measure of randomness. Much like the concept of infinity, entropy is used to help model and represent the degree of uncertainty of a random variable. It is used by financial analysts and market technicians to determine the chances of a specific type of behavior by a security or market.

BREAKING DOWN 'Entropy'

Entropy has long been a source of study and debate by market analysts and traders. It is used in quantitative analysis and can help predict the probability that a security will move in a certain direction or according to a certain pattern. Volatile securities have greater entropy than stable ones that remain relatively constant in price. The concept of entropy is explored in "A Random Walk Down Wall Street."

Entropy as a Measure of Risk

Like beta and volatility, entropy is used to measure financial risk as a measure of randomness. In the world of finance, risk is both bad and good depending on the needs of the investor; however, it is generally assumed that greater risk creates a higher probability for enhanced growth. Investors seeking higher growth are taught to seek out high beta or high volatility stocks. Entropy is used in the same way. A stock with a high level of entropy is considered riskier than others. Some analysts believe entropy provides a better model of risk than beta. It has been shown that entropy, like beta, and standard deviation go down when the number of assets or securities in a portfolio increases.

Entropy Usage

The main issue with using entropy is the calculation itself. Among analysts there are many different theories about the best way to apply the concept in computational finance. For example, in financial derivatives, entropy is used as a way to identify and minimize risk. In the traditional Black-Scholes capital asset pricing model, the model assumes all risk can be hedged. That is, all risk can be determined and accounted for. This is not always a realistic model. The concept of entropy can be applied and represented by a variable to eliminate the randomness created by the underlying security or asset, which allows the analyst to isolate the price of the derivative. In other words, entropy is used as a way to identify the best variable for which to define risk within a given system or financial instrument arrangement. The best variable is the one that deviates the least from physical reality. In finance, this can be represented with the use of probabilities and expected values. While the calculation itself is evolving, the purpose is clear; analysts are using the concept to find a better way to price complex financial instruments.

RELATED TERMS
  1. Random Factor Analysis

    A statistical analysis performed to determine the origin of random ...
  2. Random Variable

    A variable whose value is unknown or a function that assigns ...
  3. Data Smoothing

    The use of an algorithm to remove noise from a data set, allowing ...
  4. Runs Test

    A statistical procedure that examines whether a string of data ...
  5. Stochastic Volatility - SV

    A statistical method in mathematical finance in which volatility ...
  6. Beta

    Beta is a measure of the volatility, or systematic risk, of a ...
Related Articles
  1. Investing

    Financial Markets: Random, Cyclical Or Both?

    Are the markets random or cyclical? It depends on who you ask. Here, we go over both sides of the argument.
  2. Investing

    Beta: Know The Risk

    Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here.
  3. Investing

    Understanding the Random Walk Theory

    The random walk theory states stock prices are independent of other factors, so their past movements cannot predict their future.
  4. Investing

    Beta: Gauging Price Fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  5. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  6. Trading

    Random Reinforcement: Why Most Traders Fail

    This phenomenon can cause a trader to abandon a proven strategy or risk everything on chance. Find out how to avoid it.
  7. Investing

    High Beta – Low Beta Stocks Define Volatility Trades

    We compare the Beta values obtained from financial sources. Also, how to compute Beta using Excel.
  8. Financial Advisor

    Calculating Beta: Portfolio Math For The Average Investor

    Beta is a useful tool for calculating risk, but the formulas provided online aren't specific to you. Learn how to make your own.
  9. Investing

    Scenario Analysis Provides Glimpse Of Portfolio Potential

    This statistical method estimates how far a stock might fall in a worst-case scenario.
  10. Investing

    3 Cases When Beta Does Not Measure Volatility of Stocks

    Examine the theoretical and statistical relationship between beta and volatility to identify three factors that limit beta's explanatory value.
RELATED FAQS
  1. What is the "random walk theory" and what does it mean for investors?

    The random walk theory is the occurrence of an event determined by a series of random movements - in other words, events ... Read Answer >>
  2. How does my insurance company determine what premiums I have to pay for coverage?

    Learn about some of the quantitative finance measures that investors without a strong math background can use in analyzing ... Read Answer >>
  3. How does beta measure a stock's market risk?

    Learn how beta is used to measure risk versus the stock market, and understand how it is calculated and used in the capital ... Read Answer >>
  4. What are the best selection methods for creating a simple random sample?

    Discover some of the methods that researchers and pollsters utilize to select a simple random sample from a population group ... Read Answer >>
  5. What are some common measures of risk used in risk management?

    Learn about common risk measures used in risk management and how to use common risk management techniques to assess the risk ... Read Answer >>
  6. What is the best measure of a given stock's volatility?

    Understand what metrics are most commonly used to assess a security's volatility compared to its own price history and that ... Read Answer >>
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center