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 BlackScholes 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.

Random Factor Analysis
A statistical analysis performed to determine the origin of random ... 
Random Variable
A variable whose value is unknown or a function that assigns ... 
Data Smoothing
The use of an algorithm to remove noise from a data set, allowing ... 
Beta
Beta is a measure of the volatility, or systematic risk, of a ... 
Runs Test
A statistical procedure that examines whether a string of data ... 
Stochastic Volatility  SV
A statistical method in mathematical finance in which volatility ...

Markets
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. 
Managing Wealth
Beta: Know The Risk
Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here. 
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. 
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. 
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. 
Markets
High Beta â€“ Low Beta Stocks Define Volatility Trades
We compare the Beta values obtained from financial sources. Also, how to compute Beta using Excel. 
Investing
Scenario Analysis Provides Glimpse Of Portfolio Potential
This statistical method estimates how far a stock might fall in a worstcase scenario. 
Markets
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. 
Managing Wealth
What is a Security Market Line?
The security market line graphs the systematic risk versus return of the whole market at a certain time, and shows all risky marketable securities. 
Investing
Find The Right Fit With Probability Distributions
Discover a few of the most popular probability distributions and how to calculate them.

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 >> 
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 >> 
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 >> 
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 >> 
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 >> 
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 >>