Entropy [ScorsoneEnterprises]

This indicator calculates the entropy of price log returns over a user-defined lookback period, providing insights into market complexity and unpredictability. Entropy measures the randomness or disorder in price movements, helping traders identify periods of high or low market uncertainty.

How It Works

The indicator computes the entropy of log returns (log(close/close[1])) using a histogram-based approach with customizable bins. Log returns are stored in an array of size N (lookback period), and entropy is calculated by:

Binning the returns into bins intervals based on their range.
Computing the probability distribution across bins.
Calculating entropy as -Σ(p * log(p)), where p is the probability of each bin.

A reference Simple Moving Average (SMA) of the entropy, with a separate lookback period (SMA_N), is plotted to highlight trends in market complexity. The entropy plot uses a gradient color scheme (red for lower entropy, teal for higher), while the SMA color shifts based on whether entropy is above (teal) or below (red) the SMA.

Key Features

Inputs:
Lookback Period (default: 50): Number of bars for calculating log returns.
Reference SMA Lookback Period (default: 100): Period for the entropy SMA.
Number of Bins (default: 20): Number of histogram bins for entropy calculation.

Plots:
Entropy: Gradient-colored line reflecting market randomness.
Reference SMA: Trend line to compare entropy against its average.

Interpretation

High Entropy: Indicates chaotic, unpredictable price movements, often during volatile or trendless markets.

Low Entropy: Suggests more predictable, ordered price behavior, often in trending or stable markets.

Compare entropy to its SMA to gauge whether current market complexity is above or below its recent average.


Usage

Use this indicator to assess market regimes. High entropy may signal choppy, range-bound conditions, while low entropy could indicate trending opportunities. Combine with price action or other indicators for confirmation.
Examples



We see on this COCOA chart that when entropy is low it signals a strong trend, either up or down. High entropy signals indecision and choppiness in the market. We can determine this by noticing when the value is above or below its recent average.



Entropy is used in high frequency trading often. It is a nice tool for lower time frames to determine how predictable and strong a trend is.
Inputs

Users can enter the lookback value for entropy, bin count, and the look back for the entropy moving average.

No tool is perfect, the Entropy value is also not perfect and should not be followed blindly. It is good to use any tool along with discretion and price action.