entropy

Article
The Flow of Information in Trading: An Entropy
Approach to Market Regimes
Anqi Liu 1, * , Jing Chen 1 , Steve Y. Yang 2 and Alan G. Hawkes 3
1 School of Mathematics, Cardiff University, Cardiff CF24 4AG, UK; [email protected]
2 School of Business, Stevens Institute of Technology, Hoboken, NJ 03070, USA; [email protected]
3 School of Management, Swansea University, Swansea SA1 8EN, UK; [email protected]
* Correspondence: [email protected]; Tel.: +44-29-2087-0908




Received: 29 August 2020; Accepted: 21 September 2020; Published: 22 September 2020


Abstract: In this study, we use entropy-based measures to identify different types of trading behaviors.
We detect the return-driven trading using the conditional block entropy that dynamically reflects the
“self-causality” of market return flows. Then we use the transfer entropy to identify the news-driven
trading activity that is revealed by the information flows from news sentiment to market returns.
We argue that when certain trading behavior becomes dominant or jointly dominant, the market
will form a specific regime, namely return-, news- or mixed regime. Based on 11 years of news
and market data, we find that the evolution of financial market regimes in terms of adaptive
trading activities over the 2008 liquidity and euro-zone debt crises can be explicitly explained
by the information flows. The proposed method can be expanded to make “causal” inferences on
other types of economic phenomena.

Keywords: information entropy; market information flows; trading behavior identification;

news sentiment

1. Introduction
The financial market is a natural arena for information competition and investors often seek
to collect and process information to assist their investment decisions marking [1,2]. With the
proliferation of the electronic trading, the quality and timeliness of information become, in particular,
highly important for traders. Investigating how traders use information become vital to
comprehensively analyze and understand important finance problems including price formation,
price discovery and market efficiency [3–8]. Often, new financial technologies offer greater
capacity to process larger amount information more efficiently that would result in faster price
discovery [9–11] and eventually more efficient market as the Efficient Market Hypothesis (EMH) states.
However, the EMH only presents novelty of a basic classification of information used in the
financial market. New types of information such as business news that popularized through the
information technology revolution are not considered. Moreover, the advancement of financial
technologies has implicitly increased the complexity of the market; thus, how the multiple information
transmits and influences one another through trading decisions is much more complex and has
exceeded what the EMH can describe. Therefore, we endeavor to propose a new method based on
entropy to identify the roles of different information sources in price formation within the context of a
contemporary financial market.
Entropy, by definition, is proposed to calculate the amount of information contained in a
signal series. This concept is also associated with the second law of thermodynamics and is used to
calculate the change of states of a system. The modern financial market clearly forms a natural new
venue to apply such method. Up to date, there have not been many studies applying entropy to finance

Entropy 2020, 22, 1064; doi:10.3390/e22091064 www.mdpi.com/journal/entropy

Entropy 2020, 22, 1064 2 of 22

problems comprehensively. Reference [12] detected significant information transition between the Dow
Jones and the DAX indexes and [13] calculated transfer entropy of the VIX and the iTraxx Europe index
to examine relative power of market risk and credit risk. Reference [14] used Rényi’s information flow
to conduct similar experiments on S&P500 and DAX indexes. Reference [15] expanded the analysis
to of information flows of market volatility. More recent studies [16,17] brought more insights of
information flows in commodity markets. However, all these studies focused on analysis of financial
time series and statistical interpretations of financial data. To our best knowledge, there have been
no studies using entropy to describe the complex financial system based on multivariate information
flows; nor further identifying trading activities that are driven by various types of information.
The contemporary financial market is primarily based on electronic trading, and both real-time
market data and business news are two dominate types of information that feed into trading
decisions. Traders are forced to discover more information to compete with others, especially
when profitability of traditional trading rules (e.g., technical analysis) are reduced in the so-called
“zero-sum game”. Furthermore, textualization techniques have developed rapidly and it becomes a
general practice that professional traders track social media messages and business news (Humphries,
Lewis (3 February 2012). “The Power Of Social Media: Influencing Trading And The Markets.”).
Reference [18] suggests that many institutional investors and high frequency traders have adopted
news feeds to generate investment signals and determine trading timing. Several academic research
studied the relations between news sentiment and stock markets (see [19–21]). However, there has been
no study examining such relations through information flows. This is vital as we have emphasized
earlier that price formation and market efficiency are essentially driven by information transmission;
thereby, to understand how information flowing within the financial system is the key to answer these
questions. Furthermore, in the complex system, information flows would interact with one another,
which forms dynamic mechanisms among different market conditions in relation to the news and
traditional real-time market data (e.g., returns).
In Figure 1, we model the financial market as a bi-variate system, in which news sentiment and
market returns are two types of information that guide trading decisions and there are flows within and
between them. Entropy, as a way of describing the dynamic feature of the system, will be introduced
to quantify the information flows. Technically, we measure two information flows: one is the flow in
the underlying process itself and the other is from the news sentiment to price movements; and these
two flows indicate return-driven and sentiment-driven trading respectively.

Figure 1. Information flow diagram.

Entropy 2020, 22, 1064 3 of 22

Finance literature typically turns to causality analysis to understand the information transmissions
among data series. However, to model a system involving multiple series, the simple uni- or
bi-directional causal relationships become insufficient to describe the mechanism that possibly works
more like a dynamic network. Entropy is an expression of randomness or lack of information of
a system. It involves dynamic and non-symmetric measures (e.g., transfer entropy) that are able to
reveal statistical relationships regardless of data linearity and normality. Regarding this, entropy has
been applied to social networks [22], information transmission across financial assets [23–25],
causal influences and applied statistics [26–28], and in dynamic systems [29,30]. As mentioned,
a few studies have applied the transfer entropy to justify the coupling between two financial time
series (see [12,13]). In addition to the advantage in capturing non-linear relationships, the entropy
method treats information in a way that is close to how traders make trading decisions in reality.
In contrast to the standard models (e.g., VAR, Granger causality test) that present impacts of lagged
data separately, entropy takes information filtration to indicate the use of all useful information
up-to-date. Such a method apparently presents a better way to approximate real trading behavior.
Indeed, we have constructed an entropy-based modeling framework, as an alternative method to
classic modeling techniques, to describe the multiple information flows in the financial market in [31].
In this study, we extend this previous work to develop a method to identify trading behaviors
based on information sources. We believe the entropy-based information flows would allow us to
quantify the impact of the various information flow, hence, accurately categorize return-driven and
sentiment-driven trading.
We evaluate conditional entropy and transfer entropy to accommodate different trading activities
in the complex market structure and model the information flows within and between different types
of information sources (see Figure 1). We use the Thomson Reuters News Analytics database to
compute news sentiment and to enrich interpretations of news-driven trading activities. The Standard
& Poor’s 500 index (.SPX) is applied to identify the return-driven trading activities. These results
allow us to clearly distinguish two different trading behaviour. Over time, when a particular trading
pattern persists, the market may experience a regime change that could potentially contribute to the
literature on market regime and structure studies as it provides a way potentially quantifies the the
efficiency change of the market. The normal market conditions could be driven by return-driven
trading as the EMH normally hypothesized, or a mixture of return- and sentiment-driven trading that
may constantly reinforce each other. However, when the market experiences unusual conditions such
as financial crises, we observe that such patterns are disrupted. In particular, return-driven activities
lose their persistence manifested in the sharp drop of information flow. Instead, the sentiment-driven
trading becomes dominant. This means what determines the trading decisions is associated with
investors’ “needs” from the market. For example, after the bubble bursts, most investors sense fear
of crisis and their “needs” would shift from making profits to escaping losses. Not only we provide
consistent arguments with some early research such as [32–34], we bring contributions to an important
part of literature here: the financial market would always have a certain level of self-adjustment
and self-recovery ability in response to information shocks. However, once the scale of the return or
sentiment driven trading activities turn overwhelmingly dominant and exceed a certain boundary
and/or threshold, the market may move towards structural changes. This would bring new insights to
studies on market regime shifts.
To sum up, we consider the financial market as a bi-variate system composed of two types of
information: market returns and news sentiment (see Figure 1). We use information flows measured by
entropy in this system to identify trading behaviors and the potential impact of concentrated activities
in one of these trading to move the market. The rest of the paper is structured as follows. Section 2
interprets the entropy measures that are adopted to evaluate information flow and the methodologies
to formulate different types of trading activities and market regimes. Section 3 summarizes the news
and market data. Section 4 presents results of trading and market regime identification. Finally the
paper concludes in Section 5 by assessing results, contributions and limitations.
Entropy 2020, 22, 1064 4 of 22

2. Methodology
In this section, we outline the entropy-based method to evaluate information flows in the
financial system in order to detect market-, news- or mixed-driven trading activities. The rationale
of this trading behavior identification method is that investors not only adopt but also “generate”
information through their trading and these market-wide trading activities will be translated into the
information transmission process and eventually reflected in price movements. Hence, information
flows in the system reveals the type of information applied by investors into their trading decisions.
Considering the most widely adopted information sources, the information flow from market
returns to returns indicates return-driven trading while that from news sentiment to market returns
indicates news-driven trading. These two types of trading can coexist, which coincides with a mixed
impact to market and we call it mixed-driven trading. To further characterize the overall market
situation, we establish information-based market regimes that are linked with trading behaviors,
namely the return-driven, the news-driven, and the mixed (both return and news) regimes to
demonstrate the market-level shifts that caused by dominant impacts from these trading activities.

2.1. Entropy, Information Flows and Trading

The financial market that evolves through information transmission can be framed into a bi-variate
system with two information sources: market returns and news sentiment. To start, we define notations
in the financial market model. The market return series is denoted by R = {r1 , r2 , r3 , . . .} and the
news sentiment series is denoted by S = {s1 , s2 , s3 , . . .}. These two types of information can form
four information flows transmission (see Figure 1) that have been well explored in our previous
work [31]. To directly observe and classify trading behaviors, we only need to consider the information
flows that ultimately reflect price movements, namely: (1) market returns → market returns (IR→ R );
(2) news sentiment → market returns (IS→ R ). Market returns and news sentiment are sources of
information transmit in IR→ R and IS→ R respectively, ultimately drive the underlying price process to
evolve. From the perspective of traders, they often analyze market data and news and respond to them
directly to make investments. Aggregation of the these decision making activities drives market prices
to fluctuate or the entire market condition to shift (e.g., herding behaviour). Therefore, if we identify
information flows targeting the changes of the market returns, we can find out what causes the market
movements, which is consistent with the theory of price discovery. We establish information entropy
as a measure to demonstrate complex causality relationships in the financial system. We describe the
relation between an information flow (e.g., IR→ R ) as “self-causality” (see [35]) and the relation between
two different information flows (e.g., IS→ R ) as “cross-causality”. We present how to quantify them
using conditional entropy and transfer entropy respectively in the following sections.

2.1.1. Entropy Measures

If the event space X is a time series, it involves a special case of joint probability space—the
observations of sub-series. If we denote k as the number of consecutive observations until time t as
(k) (k)
xt = xt , xt−1 , . . . . . . , xt−k+1 , the entropy of xt+1 that is conditioned on previous observations xt can
be written as Equation (1).

(k) (k)
h X ( k ) = HX ( x t +1 , x t ) − HX ( x t )
(1)
= − ∑ p( xt+1 , xt ) log2 p( xt+1 | xt )
(k) (k)

in which HX is the Shannon entropy defined as

HX = − ∑ p( xt ) log2 p( xt ).
Entropy 2020, 22, 1064 5 of 22

(k)
Please note that the summation in this equation is over all possible values of ( xt+1 , xt ) for fixed
t, but if the time series X is stationary, the result h X (k) will be independent of t. This is also called
conditional block entropy, in which k is the block length. Increasing k will result in decreasing h X (k ) as
long as xt−k contains more information than xt−k+1 to forecast xt+1 [12]. Here, k can also be interpreted
as the memory length of X if and only if h X (k) = h X (k + 1).
Schreiber [36] proposed the transfer entropy that quantifies asymmetric dynamics of two processes
(k) (l )
(Equation (2)). It denotes that, despite information collected from xt , information in yt may also be
(l )
valuable in the prediction of xt+1 . Obviously, TY → X (k, l ) = 0 if yt has no additional influence on xt+1
(k)
after subtracting information already involved in xt .

(k) (l )
p ( x t +1 | x t , y t )
∑ p(xt+1 , xt , yt ) log2
(k) (l )
TY → X (k, l ) = (k)
(2)
x,y p ( x t +1 | x t )

Indeed, the transfer entropy can be formulated using conditional block entropy (see Equation (3)).

(k) (l )
p ( x t +1 | x t , y t )
TY → X (k, l ) = ∑ p( xt+1 , xt , yt ) log2
(k) (l )
(k)
x,y p ( x t +1 | x t )
= ∑ p( xt+1 , xt , yt ) log2 p( xt+1 | xt , yt ) − ∑ p( xt+1 , xt ) log2 p( xt+1 | xt )
(k) (l ) (k) (l ) (k) (k)
x,y x
(3)
 
(k) (k)
=h X (k) − HX,Y ( xt+1 , xt , ylt ) − HX,Y ( xt , ylt )
=h X (k) − h X,Y (k, l )

in which the second term h X,Y (k, l ) indicates the conditional entropy of X give the block information of
both xtk and ylt . This transformation suggests that the transfer entropy TY → X (k, l ) evaluates the amount
of information explained by ylt when xtk is already taken into account.

2.1.2. Entropy as a Causality Measure

In finance studies, whether a factor produces significant impacts to markets is usually examined
by the Granger causality test. However, the normality and linearity assumptions of this test can
cause inaccurate results for financial data. For instance, when we consider price movements,
they do not always nicely follow the random walk, instead, trends, reversal as well as seasonal
patterns are often observed and used as analyst tools that are impossible to be well modeled linearly.
Furthermore, when the financial system’s complexity increases as our bi-variate system indicates,
the impacts of news to the market would be too complex to be captured by a linear model.
Entropy measures, in contrast, will be able to offer better and more flexible ways to test and quantify
impacts of a variety of information to price movements. In fact, when observations in a time series are
independent, the entropy would not reduce by involving memory of previous observations; when
two time series are independent from each other, the transfer entropy between them will be zero.
Moreover, when the variables involved in the system are multivariate normal, the transfer entropy
would be equivalent to the Granger causality test. The equality between the causality and entropy
measures can be present the following three theorems and we provide proofs in the Appendix A
(also see [31]).

Theorem 1. If X is a sequence of i.i.d. random variables, then there is no self information flow within the series
X i.e., the conditional block entropy shall be equal to the Shannon entropy.

Theorem 2. For two independent series X and Y, the transfer entropy between them will be zero (i.e., no causal
relationships between X and Y).
Entropy 2020, 22, 1064 6 of 22

Theorem 3. Granger causality and transfer entropy are equivalent if all variables involved are distributed as
multivariate normal distributions.

Therefore, entropy measures, in theory, should not only provide consistent results with the
classic methodologies for Gaussian variables that have linear relationships, but also accommodate
non-normal and non-linear properties that standard methods would fail to identify. In addition,
entropy measures enable the idea of capturing impacts of a block of information which is far
better in describing the information processing behavior in real trading practice than the standard
models (e.g., vector autoregression, Granger causality test) which presents impacts of different
“lags” separately. These features will, inevitably, make entropy measures more suitable and robust
for financial modeling of a complex market. We have provided the detailed comparison between the
entropy and linear modeling of our bi-variate system that approximates the financial market in the
Appendix B and the conclusion is that the linear models are less consistent and entropy approach
provides additional insights, especially when dealing with a new type of financial data, such as
‘news sentiment’.
In the financial market, what would fundamentally move the prices is trading activities,
i.e., price increases with rising buying power and vise versa. The entropy measures (see Section 2.1.1)
quantify the changes of states given previous information. In our model, they can indicate traders’
responses to different information with subsequent price movements. To be specific, the conditional
block entropy of the return series tells how traders responding to price information and the transfer
entropy from news to returns explains how traders reacting to news information. In this way,
the information flows that are measured by entropy, albeit not a typically causality measure,
can effectively show causality properties in our bi-variate system.

2.1.3. Information Flow Measures

The “self-causality” property, or memory of the return series describes the information flow IR→ R
and it can be quantified by conditional block entropy as described in Section 2.1.1. We denote ∆ X (k ) as
(k)
the contribution from memory xt (see Equation (4)). The larger block size k, the larger ∆ X (k ); in our
context, it shows the length of the memory available to estimate subsequent price movements and
subsequently, return changes.
∆ X ( k ) = HX − h X ( k ) (4)

In Figure 2, we demonstrate that ∆ X (k) increases until k reaches the memory length k X . It is
clear that the conditional block entropy h X (k ) reduces with the increase in the contribution of the
memory ∆ X (k ).
The information flow IS→ R can be regarded as the causal relationship from news sentiment to
market return. Hence, we adopt transfer entropy TS→ R to evaluate the amount of information in news
that is useful for “forecasting” market returns (see the definition in [36] and Equation (2)). Please note
that TS→ R excludes the information transmission from the past market data (returns to returns) and
this requires the block size of the return series to be as large as possible in order that the self-causality
can be fully extracted. Ideally, the block size of the target information process k should be at least
equal to the memory length to ensure the robust measure of self-causality. In contrast, the block
size of the source, which is the news sentiment in our case, can be determined arbitrarily as it is
upon us to decide how far back we would like to trace the influence. These calibration settings of
information flow measures are consistent with the understanding from the information discovery
literature that historical market data (e.g., prices, returns) is always directly observable and is the most
straightforward information to incorporate in trading strategies; hence, in price forecasting, any other
information (i.e., news sentiment) must be supplementary information in addition to the full use of
market returns.
Entropy 2020, 22, 1064 7 of 22

Figure 2. Conditional entropy h X (k ) vs. reduced uncertainty ∆ X (k). Note: These results are calibrated
through a simulation sample of 1, 000, 000 observations.

Another technical issue of to note when applying the entropy measures to evaluate information
flows is that they are not directly comparable as their values’ boundaries are different and depend
on the sample and parameter selections (see Equation (5)). This has been documented by [12]
and we, thereby, follow their approach to linearly map the values to [0.0, 1.0] in order to produce
comparable values.
(
0 ≤ h X ( k ) ≤ HX
(5)
0 ≤ TY → X (k, l ) ≤ h X (k )
Finally, we can write down the two information flows as follows:

- market returns → market returns (IR→ R )

∆R h
IR → R = = 1− R (6)
HR HR

- news sentiment → market returns (IS→ R )

TS→ R
IS→ R = (7)
hR

2.2. Trading Activities Identification

As discussed before, our focus is to categorize the trading behavior through examining the price
discovery based on two types information flows in Equations (6) and (7). The trading behaviors are
separated by the information sources that drive the trading and we subsequently get:

- Return-driven trading: Investors are used to follow the market price patterns when making their
trading decisions, which is called technical analysis. Such behavior can be identified through
self-information flows of market returns. In other words, the memory of market return flow IR→ R
is the evidence of return-driven trading according to our model.
- News-driven trading: This often reflects digitization of textual information that allows investors
to effectively form beliefs through news and incorporate them into their trading decisions.
Entropy 2020, 22, 1064 8 of 22

Such trading strategies pass news sentiment to the market; hence, IS→ R indicates occurrence of
news-driven trading.

To sum up, we can form Equation (8) that categorize different types of trading: Positive self
information flows in returns define return-driven trading and positive transfer information flows from
news sentiment to returns indicate news-driven trading. In the actual modeling, we set the precision
of information flows with 4 decimal digits, so that a value lower than 1 basis point will be regarded
as 0. Here we concentrate on identifying trading behavior through direct information transmissions
at the market level in this bi-variate system and do not go into a further classification of uncommon
trading behaviors at micro levels. Hence, we label “other types of trading” relative to the two kinds of
trading activities mentioned above in Equation (8).

Return-driven trading,

 IR → R > 0
Ltrading (t) = News-driven trading, IS→ R > 0 (8)


Other types of trading, Others

2.3. Market Information Regime

When viewing the trading activities at the (aggregated) market level, especially when a certain
type of trading pattern persists and becomes dominant, it could lead to a market regime. Based on our
trading classification, we can count three possible market regimes that are sketched out in Equation (9).



 Return-driven, IR→ R > 0 and IS→ R = 0


News-driven, IS→ R > 0 and IR→ R = 0
Lregime (t) = (9)


 Mixed, IS→ R > 0 and IR→ R > 0

Other types,

Others

1. The return-driven regime: The market is purely driven by chasing of return patterns. We often
obtain stronger return memory in this regime.
2. The news-driven regime: The market prices moves entirely from responses to news and no
self-causality in returns are detected.
3. The mixed regime: Both return-driven and news-driven trading were identified and they co-exist.
4. Other types: Neither return-driven nor news-driven trading were detected. The market either
react to news and market data too slow to produce significant information flows, or have too few
traders using these types of information to form market-level price impacts.

2.4. Parameter Settings and Some Calibration Issues

The original data of both market returns and news sentiment are continuous. Instead of fitting
the continuous probability density function, we label 3 groups for each of the two time series
(see Equation (10)). The labels of market returns capture the price movements of up-trend, no-trend
and down-trend; and the labels for news sentiment highlight good, neutral and bad financial/business
news. The reasons for using discrete probabilities are twofold. First, estimating continuous probability
density functions is both data-intensive and computing-intensive. Second, investors usually make
decisions based on their optimistic or pessimistic prospect, for example forecasting of bull and bear
market, or chasing positive returns.

−1,

 x (t) < µ − d
L(t) = 0, µ − d ≤ x (t) ≤ µ + d (10)


1, x (t) > µ + d
Entropy 2020, 22, 1064 9 of 22

When labeling the returns or sentiment, we refer to the data partition approach in [12] that finds a
threshold d to group the 3 states into approximately the same probability (i.e., p( L = −1) ≈ p( L =
0) ≈ p( L = 1) ≈ 13 ). The literature often adopts a so-called “optimal alphabet partition problem”
for data discretization. However, according to [12], equal probability partition fits better to our
problem considering the advantages of “neutralising undesirable effects due to very in-homogeneous
histograms and ignoring the trivial information gain obtained by just observing marginal distributions.”
As an important technique for information disclosure, equal probability partitioning has been well
explored in the literature (see [37–39]). The implementation of this partitioning method is introduced
in Appendix C.
The accuracy of entropy calibration relies highly on the sample size. Theoretically, the sample
size should be much larger than the number of events in the probability space to avoid systematically
undervaluing entropy. However, this criterion may not be satisfied due to the exponentially increasing
number of events with increasing block sizes. We demonstrate this in Figure 3 and it is clear that a
small sample size leads to significant undervaluation, especially poor ability to uncover the number
of events within the probability space. In contrast, a much larger sample size would provide stable
estimations; however, is unrealistic to obtain that many data observations.

Figure 3. Small sample bias of h I (k). Note: This is an interpretation of systematically undervaluing
conditional entropy due to small sample size. This calibration issue exists in transfer entropy as well.
These values are calibrated through a simulation sample of 1, 000, 000 and 3000 observations.

To address this issue, we apply the method introduced by [40] to estimate entropy through
fitting a monotonically decreasing frequency function. The rationale of this method is that most
statistical properties, including entropy, are purely a matter of probability density so that the order of
events can be ignored. The key of this method is to design a function that can be turned to different
shapes but not too complex. Reference [40] confirmed the best results in their experiments can be
presented as follows: 
− 31
α(k − e) , 1 ≤ k ≤ β


p(k) = φk−δ , β≤k≤γ (11)


0, k>γ
Entropy 2020, 22, 1064 10 of 22

This estimation approach is applied on both conditional block entropy and transfer entropy.
To fully capture the strength of self information flow, we need to solve the optimization problem of the
memory length k X (see Equation (12)).

k X = arg max ∆ X (k) (12)

k

In practice, the cut-off memory length may not be as clear as the simulated samples in Figure 3
due to limited sample size or data noise so that such strict selection criteria may not be applicable.
We set a threshold c = 10% which the first k that satisfies Equation (13) can be determined for the
memory length of X (see Figure 4 showing the optimal block length of memory).

∆ X ( k ) − ∆ X ( k − 1)
<c (13)
∆ X ( k − 1)

Figure 4. Annotation of memory length optimization and selection

As indicated above, in transfer entropy TY → X (k, l ), the block size of X should be the optimized
value k = k X . In addition, we only test one period cross-sectional influence so that the block size of Y
is always fixed to l = 1.
In this study, all information entropy measures are calculated through a rolling window of 1-year:
the window rolls on daily basis and the window length is one year that gives sufficient observations to
capture any major statistical relations in the market even under the extreme market conditions such as
a crisis. Within each moving window, we have around 3300 time series observations at a 30-min data
frequency (detailed data descriptions are in Section 3). We firstly compute the daily information flows
then average them to a weekly frequency. Intuitively, the daily information flow should not change
dramatically, while some noise in calibration may be inevitable. The reason that we roll the window
on a daily basis is to reduce calibration bias in the weekly proxies.

3. Data
The market and financial news sentiment data for this research are obtained from Thomson
Reuters Tick History (TRTH) and Thomson Reuters News Analytics (TRNA) respectively. The dataset
is in 30-min frequency from 1 January 2003 to 31 December 2014, excluding non-trading hours.

3.1. Financial Market Data

Stock market indices are proxies of equity market movements. In this study, we use S & P 500
(.SPX) index prices to represent the U.S. stock market. This index involves large-cap equities which
Entropy 2020, 22, 1064 11 of 22

usually have high trading liquidity so that the price movements are sensitive to traders’ responses to
real-time information. In other words, information flows can be most accurately measured without
being affected by transaction issues. We collect 30-min intraday prices of the market index from
TRTH database.

3.2. News Sentiment Data

In this research, we select TRNA data to compute news sentiment for two reasons.
First, Thomson Reuters is a top financial data vendor, providing complete and reliable news data
feeds. Second, TRNA is a professional news sentiment database that has been adopted by
previous studies [41]. TRNA adopts natural language processing techniques to read and score
news articles in real time (TRNA is a component of Thomson Reuters Machine Readable News.
Detailed introductions can be found in https://developers.refinitiv.com/sites/default/files/
ThomsonReutersMRNElektronDataModelsv210_2.pdf). In the TRNA database, sentiment is measured
as positive, negative and neutral probabilities which allow us to customize the formula for our
sentiment score. In addition, it provides a separate record for each company mentioned in every
single piece of news articles to show relevance of the news to individual stocks. The relevance score
suggests whether a company plays a main role in the news. It is common that a news article has strong
sentiment while weak relevance to some stocks mentioned in it. We use the relevance score to tune the
sentiment to a lower level in this case.
The metadata fields we used for sentiment calibration in this paper are listed below.

- datetime: The date and time of a news article.

- ric: Reuters Instrument Code (RIC) of a stock for which the sentiment scores apply.
- pos, obj, neg: Positive, neutral, and negative sentiment probabilities (i.e., pos + obj + neg = 1).
- relevance: A real-valued number between 0 and 1 indicating the relevance of a piece of news
to a stock. One news article may refer to multiple stocks. A stock with more mentions will be
assigned a higher relevance.

To evaluate the sentiment score of each record (i.e., one score per news per stock), we calculate
the expectation of sentiment probabilities adjusted by relevance value (see Equation (14)).

Sentiment = relevance × (pos − neg) × (1 − obj) (14)

As we use the .SPX to represent the U.S. market, we track the components of this index over time
and only count the news related to these stocks. Changes of the .SPX index constituents are obtained
from The Compustat. Then we define 30-min news sentiment as the average sentiment of all records
published within the time interval. The news released in non-trading hours are counted into the first
30-min of the following trading day.

3.3. Stationarity Test

We apply the augmented Dickey–Fuller (ADF) test on the price data, log-returns, and news
sentiment. The null hypothesis is that there is a unit root. The results in Table 1 show that for returns
and sentiment, the null hypothesis is rejected at a strong 99.9% confidence level. In contrast, the price
series is apparently non-stationary as expected. These results confirm that our model setting of using
returns and sentiment for information flow computation is valid.
Entropy 2020, 22, 1064 12 of 22

Table 1. ADF test results.

t-Statistic p-Value
Price level −0.631 0.864
Log-return −27.092 0.000
News sentiment −10.901 0.000
Null hypothesis: there is a unit root. Alternative hypothesis: the time series is stationary. Regression model includes
a constant and no trend.

4. Results
We highlight two types of information flows as proxies of trading behaviors in Section 2: IR→ R
for return-driven trading; and IS→ R for sentiment-driven trading. We present key findings of these
information flows in this section.
IR→ R is a self-causality information flow, which can be regarded as the “memory” of the return
time series. The memory length and strength are equivalent to the block size and the standardized
entropy value. From the time series perspective, return memory is associated with a price trending or
reversal pattern, and the strength of memory indicates the scale of the dominance of such patterns
over the price movements. According to Figure 5, the memory strength of market returns clusters into
three time periods: pre-crisis (before 2008), crisis (2008–2011, covering both 2008 liquidity crisis and
EuroDebt crisis) and post-crisis (after 2013). As self information flow IR→ R is the return-driven trading
proxy, we observe that most return-driven trading responses to market based on the past two 30-min
periods (1 hour) in the pre- and post-crisis. We also observe that stronger information flows coincide
with strong memory length (e.g., the strongest IR→ R has reached 0.05 in late 2014).

Figure 5. Self information flow (memory) of market returns (2004–2014).

Recall that we consider a 1-year rolling window to incorporate sufficient data to obtain the
optimal memory length reflecting the impact on the market. In this case, the information flow
of each point at time t actually represents an accumulative effect of the past year prior to time t.
Therefore, the self-causality of market returns, which appears in a cyclic pattern, is closely associated
with events such as financial crises that are often triggered by persistent pre-crisis activities and
spread with contagions after the outbreak of crises. During the crisis period, however, there are a few
interesting and unique findings. First, throughout the 2008 crisis and early period of the EuroDebt
crisis (August 2008 to November 2011), both the memory length and strength have stayed at zero.
Entropy 2020, 22, 1064 13 of 22

We think it is because both the 2008 liquidity crisis and 2011 EuroDebt crisis have caused fundamental
structural changes to the market and led to investors’ completely different ways to respond after being
shocked during this period. This period began just before the Lehman’s official filing of bankruptcy
and endured for some time even until the occurrence of the EuroDebt crisis.
No one is sure how long exactly that the 2008 crisis may have affected the market; but inevitably,
the Eurozone sovereign debt that started in early 2010 could only make the market more stressed.
This explains why return memory suddenly dropped and remained absolutely static at the
zero position, which also indicates traders stayed away from return-driven trading activities.
However, differing from the 2008 crisis, the European Central Bank (ECB), together with the European
Financial Stability Facility (EFSF) and European Stability Mechanism (ESM), had swiftly taken a
much more systematic approach to solve the EuroDebt crisis and the market started to calm down
subsequently (The ECB, on 6 September 2012, extended its approach by providing free unlimited
support for affected countries through the EFSF/ESM’s state bailout/precautionary program).
Therefore, the information flow of market returns, in terms of both memory length and strength,
picked up from late 2010. Another reason the entropy memory length and strength are partially
affected during the EuroDebt crisis could be that the cross-market spillover effects were not as strong
or long-lasting as the 2008 crisis’ direct impact on the US market. When the market calmed down
even further since 2013, the memory length came back to the pre-crisis level of 1 h and the strength
outweighed the maximum of pre-crisis level (0.05 vs. 0.03).
The other information flow IS→ R is the proxy for news-driven trading. In Figure 6, we observe
that, similar to the return-driven trading, the news-driven trading is persistently involved in the
market. The only exception is from late 2011 to early 2013, right after the EuroDebt crisis. It is also the
period that the market started to pick up after a few years of downturn. As return updates faster than
news, the absence of news-driven trading reflects the adaptiveness of investors. They tend to firstly
response to the more timely and better organized information. We also observe that the information
flow IS→ R existed during the 2008 crisis: in contrast with the IR→ R , which stayed zero. It confirms our
previous argument that investors changed their way of trading after the bubble burst, from responding
to price patterns to decisions on beliefs of news. Similar to the memory of return, IS→ R also increased
sharply with the market recovering from 2013.

Figure 6. Information flow from news sentiment to market return (2004–2014).

We identify market regimes using the criteria described in Equation (9) and these regimes
are formed through different trading activities. We focus on explaining three market regimes,
Entropy 2020, 22, 1064 14 of 22

namely return-driven, news-driven and the mixed regimes (see Equation (9)). Technically,
these regimes are recognized if the information flow exceeds 1 basis point, the precision we set
for all information flow measures. Because our information flow is calculated with a 1-year rolling
window, it actually reveals insights of traders’ behavior in the past. This is highly important in that the
trading behaviors detected in the market actually reflects the accumulative effects of historical trading
activities, rather than just the contemporary trading impact on the market. For instance, Figure 7
suggests that, in the first half of 2010, the market should be relatively slow moving because in almost
the first 10 months in 2010 it appears to lack signs of both news-driven and return-driven trading
(we define it as “other types” in Equation (9)). In fact there is no sign of market-driven as far back as
early-to-mid 2009. Nobody in the market would disagree with this finding as this is not long after
the official filing of the bankruptcy of Lehman in August 2008. The market has already been severely
shaken, market participants are extremely cautious, and regulators are highly alerted.

Figure 7. Market regimes.

From Figure 7, we summarize below the key results regarding market regimes:

- There are two periods within which the market regime is driven by a single type of trading
activity: (1) from the Q3 of 2008 to the Q4 of 2010, the single source of market-wide trading is news
sentiment (blue bars only); while (2) from the Q4 of 2011 to the Q3 of 2012, the return memory
clustering indicates return-driven activities that drive the market movements (green bars only).
Before and after the news-driven regime (period 1 here), we spot a swift switch from returns
to sentiment. However, for the return-driven regime (period 2 here), instead, it is more of the
fact that news influence disappears from a mixed-regime. These signs are important because
they could be highly indicative. They show that news sentiment always requires longer time to
form compared to the belief towards some fast updating changes in the market (e.g., reflected
in returns).
- During the rest of the time, price movements are caused by mixed types of trading. In addition,
the mixed regime demonstrates strong features associated with the market crisis timeline.
In the pre-crisis period (before 2008), although there exists trading of both returns and news,
often return-driven trading overpowers the news-driven (apart from one exceptional spike of
news event around October 2010); while in the post-crisis period (after 2013), the dominance
Entropy 2020, 22, 1064 15 of 22

more often resides in the power of news-driven trading, moreover, at a much higher level than
the return-driven. This finding is of great interest to us because it provides strong evidence
of the change in the market regimes’ dynamics before and after the double crisis period.
Furthermore, the imbalance between their dominants within the mixed regime has changed
dramatically and more frequently in the post-crises years. We see a few flash spikes in news-driven
trading, while there was only one spike showing clear imbalance around October 2004 during the
pre-crisis period. All these suggest that the complexity of the market may have increased after the
crises with the growth of modern technology and big data [42].

These observations highlight an adaptive pattern of investors’ trading behaviors, which naturally
imply the dynamics of underlying information discovery: before the 2008 financial crisis, the global
economy enjoyed a few years of boom and investors were confident and optimistic about the bull
market and kept chasing prices [43]. During the same time period, digitization of textual information
allowed business news to be widely adopted in investment decisions. Access to innovative information
brings new opportunities for excess returns. This explains why the news-driven trading was actively
involved, but not primarily dominant, in the financial market during the pre-crisis period.
In the double crisis periods, trading activities were mainly led by news. This is because,
under the extreme market condition, the underlying price generating process was apparently far
from what could be interpreted by widely adopted financial models. The market has been gloomy
and the general confidence of price movements are destroyed as market participants are confused.
Therefore, we observe the trading dominated by news and the investors were very “quiet” toward
market return information. There was a short time (around March to June, 2012) that no particular types
of market activities or regimes could be identified. Most investors were managing their investment
passively and panic about unforeseen changes.
Finally, investors cannot obtain full information transparency. This argument links the market
efficiency problem to the information competition among investors. To be more specific, when the
majority of investors hold back in the information competition, gaps of price discovery start to emerge.
Therefore, after a few years of weak or no trading using news and returns, an even stronger information
flow shows up from 2013. In addition, as we summarized before, the market has become much more
complex, even in the formation of news sentiment. At the same time, with the rapid growth in new
financial technology and data science, the complexity of the financial system has been further enhanced
through complex trading techniques, for instance, ultra-high frequency trading.

5. Conclusions
This study is innovative in applying information entropy to identify trading activities.
In our model, the financial market is considered as a bivariate system of news sentiment and
market return. Entropy measures the causality relationships of these two time series to indicate the
information flowing in this system. We argue that information transmission in this system represents
two types of trading behaviors: return-driven trading that can be identified through self-causality of
market return, and news-driven trading which is revealed by the cross-sectional information flow
from news sentiment to market return. From the economic perspective, this study applies 11 years
of news sentiment and market data to show the evolution of financial market regimes in terms of
adaptive trading activities. The proposed method can be expanded to study more comprehensive
types of information that lead to trading decisions.
There are some limitations in this study. We recognize there are different approaches to measuring
news sentiment [19,20]. We use a commercially available one from Thomson Reuters. We recognize
that there is no universally agreed news sentiment measure, nor a universally adopted method to
map textual information to investor beliefs. The accuracy of such a measure may affect the “level of
sentiment information used in trading”. Nevertheless, all different investor sentiment measures have
been approved correlated, and there is always a need for better quality and reproducibility of the
proposed measures [44,45]. Although such variance may not affect the main findings we document
Entropy 2020, 22, 1064 16 of 22

in this study, the differences in effect and accuracy should be examined. Moreover, this study only
focuses on news-driven and return-driven trading behaviors. We are silent about other types of trading
activities, if any, and consequently more market regime delineations. We recommend future studies to
discover other behaviors using or extending the proposed methodology, and examine their effects on
the market price formation.

Author Contributions: Conceptualization, A.L. and S.Y.Y.; methodology, A.L. and J.C.; software, A.L.; validation,
J.C. and A.G.H.; formal analysis, A.L. and J.C.; investigation, A.L.; resources, S.Y.Y. and A.G.H.; data curation, A.L.;
writing—original draft preparation, A.L.; writing—review and editing, A.L., J.C., S.Y.Y. and A.G.H.; visualization,
A.L. and J.C.; supervision, S.Y.Y. and A.G.H.; project administration, A.L. All authors have read and agreed to the
published version of the manuscript.
Funding: This research received no external funding.
Acknowledgments: The authors would like to thank the discussants at the 25th Annual MFS Conference, the 2nd
European Capital Market Workshop on Microstructure, 1st International Forum on Financial Mathematics and
FinTech for insightful comments and discussions while preparing this paper. This work has been presented in
the following schools: School of Management in University of Bath, Department of Accounting and Finance
in University of Stirling, School of Management in Swansea University, School of Statistics in Beijing Normal
University, School of Statistical Science in Beijing University of Technology, School of Management in Beihang
University, and Wanyanan Institute of Economic Studies in Xiamen University. We would also like to show our
gratitude to researchers participated in these seminars for sharing their insight and expertise.
Conflicts of Interest: The authors declare no conflict of interest.

Appendix A
This appendix presents proofs of theorems of well-known facts related to entropy measures.

Theorem A1. If X is a sequence of i.i.d. random variables, then there is no self information flow within the
series X i.e., the conditional block entropy shall be equal to the Shannon entropy.

Proof. For an i.i.d. sequence X, we have

(k)
p ( x t +1 | x t ) = p ( x t +1 ) (A1)
(k) (k) (k) (k)
and p( xt+1 , xt ) = p( xt ) p( xt+1 | xt ) = p( xt ) p( xt+1 ) (A2)

Then from Equation (1)

h X (k) = − ∑ p( xt+1 , xt ) log2 p( xt+1 | xt )

(k) (k)

= ∑ p( xt ){− ∑ p( xt+1 ) log2 p( xt+1 ))}

(k)
(A3)
= ∑ p ( x t ) HX
(k)

= HX

(k)
Since ∑ p( Xt ) = 1.

Theorem A2. For two independent series X and Y, the transfer entropy between them will be zero (i.e., no causal
relationships between X and Y).

Proof. For the two series X, Y, the transfer entropy satisfies Equation (2).
(k) (l ) (k)
If the two series are independent, we have p( xt+1 | xt , yt ) = p( xt+1 | xt ). Then for all possible
series values the logarithmic term in the above expression becomes log2 (1) = 0.
So TY → X = 0 for any positive integers k and l.
Similarly, TX →Y = 0 as well.
Entropy 2020, 22, 1064 17 of 22

Theorem A3. Granger causality and transfer entropy are equivalent if all variables involved are distributed as
multivariate normal distributions.

Proof. This is a more succinct proof of a result of [27]. For any random vector Z with probability
density f ( Z ) the entropy is defined as
Z
H (Z) = − f (z) ln f (z)dz = − E[ln f ( Z )]. (A4)

Please note that we are using ”Natural” logarithms rather than base 2 logs that are common in
information theory. If Z has multi-Normal distribution Z ∼ MN (µ, Σ( Z )) the probability density is
1 1
f (z) =(2π )− 2 dZ |Σ( Z )|− 2 (A5)
 
1
exp − (z − µ)0 Σ( Z )−1 (z − µ) ,
2

where d Z is the dimension of Z. Then

1 1
H (Z) = d Z ln(2π ) + ln |Σ( Z )| (A6)
2 2
1
+ E[ ( Z − µ)0 Σ( Z )−1 ( Z − µ)].
2
However, the quadratic form in the final term has a chi-squared distribution with d Z degrees of
freedom, and so has expectation d Z . Therefore

1 1 1
H (Z) = ln |Σ( Z )| + d Z ln(2π ) + d Z (A7)
2 2 2
1 1
= ln |Σ( Z )| + d Z ln(2πe).
2 2
!
X
Now let Z = , then Equation (A5) can be written as
W

f ( z ) = f ( w ) f ( x | w ), (A8)

where f (w), similar to Equation (A5),

1 1
f (w) =(2π )− 2 dW |Σ(W )|− 2 (A9)
 
1 0 −1
exp − (w − µW ) Σ(W ) (w − µW ) ,
2

The conditional density is

1 1
f ( x |w) =(2π )− 2 dX |Σ( X |W )|− 2 (A10)
 
1
exp − ( x − µ X |W )0 Σ( X |W )−1 ( x − µ X |W ) ,
2

where the conditional dispersion matrix is

Σ( X |W ) = Σ( X ) − Σ( X, W )Σ(W )−1 Σ(W, X ) (A11)

Entropy 2020, 22, 1064 18 of 22

with
! !
X Σ( X ) Σ( X, W )
Σ( Z ) = Σ = . (A12)
W Σ(W, X ) Σ (W )

Please note that from Equations (A5) and (A8) to (A10)

|Σ( Z )| = |Σ(W )||Σ( X |W )|. (A13)

(k) (l )
Let xt+1 , xl , yt have a multivariate Normal distribution. Then transfer entropy is

(k) (k) (l )
TY → X (k, l ) = H ( xt+1 | xt ) − H ( xt+1 | xt , yt ) (A14)
1 (k) 1
= ln |Σ( xt+1 | xt )| + ln(2πe)
2 2
1 (k) (l ) 1
− ln |Σ( xt+1 | xt , yt )| − ln(2πe)
2 2
(k)
( )
1 Σ ( x t +1 | x t )
= ln (k) (l )
2 Σ( x | x , y )
t +1 t t

(k)
The argument of the logarithm is just the ratio of the variance of xt+1 conditional on xt and
(k) (l )
the variance of xt+1 conditional on both xt
and yt
. As we are dealing with multivariate Normal,
these are calculated by appropriate forms of Equation (A11), which is a standard result for linear
regression (whether or not distributions are Normal). This is therefore exactly the criterion that is
used to determine whether Y Granger causes X, and so Granger causality and transfer entropy are
equivalent if all variables involved are distributed as multivariate Normal.

Appendix B
We apply the vector autoregression (VAR) and Granger causality tests on the entire dataset to
build a linear model of our bi-variate system. This model is then compared with a model using
entropy measures. We set the maximum lags of 6 for both groups of models, then choose the optimal
lag and memory length using information criteria or the method proposed in this paper respectively.
The optimal lag selected for the VAR model according to the Akaike information criterion (AIC)
is 6. As our focus of trading activity identification only considers the lagged impacts of return and
sentiment to the return series, we only tabulate the equation of return in the VAR model (see Table A1).
Using a 95% confidence level, we find the lag-2 and lag-6 return coefficients and the lag-4 sentiment
are significant. The VAR model considers information of different lags separately. Hence, we would
see “jumps” of lags. In contrast, entropy measures take information filtration to identify lagged impacts.
For example, the conditional block entropy of lag-n indicates how much uncertainty of the current
data is explained by information from n-period ago to right before the present. Apparently, the amount
of information increases with lags so that reduces entropy gradually (see Figure A1). As traders would
not intentionally skip certain time periods while gathering information for trading, the idea of entropy
matches better with the real trading activities.
Entropy 2020, 22, 1064 19 of 22

Table A1. VAR model results.

Coefficient T-Stat P-Value

Const. 0.0000 0.235 0.814
Lag-1 return 0.0018 0.352 0.725
Lag-1 sentiment 0.0003 1.086 0.278
Lag-2 return 0.0129 2.546 0.011
Lag-2 sentiment −0.0001 −0.227 0.821
Lag-3 return 0.0079 1.574 0.116
Lag-3 sentiment −0.0002 −0.900 0.368
Lag-4 return 0.0014 0.278 0.781
Lag-4 sentiment 0.0006 2.320 0.020
Lag-5 return −0.0025 −0.489 0.625
Lag-5 sentiment −0.0003 −1.057 0.290
Lag-6 return −0.0208 −4.121 0.000
Lag-6 sentiment 0.0001 0.290 0.771

Figure A1. Decreasing entropy with increasing information memory.

According to the memory length selection method introduced in this paper, we get the optimal
3-period memory for return data, which is shorter than the selection of 6 lags for the VAR model.
As explained above, this is because the VAR model tends to omit the impacts of some insignificant
lags due to the linearity assumption and as a result missed some information. Using this memory
length, we get the information flow from lag-1 sentiment to return is 10 basis point, which is much
lower than the 1.55% information flow from return to itself. This is consistent with the linear model
results above that coefficients of lagged sentiment is much smaller than those of lagged returns.
Furthermore, despite the fact that traders are actively tracking news updates in trading, the Granger
causality test fails to identify the impacts from sentiment to return (see Table A2).
Entropy 2020, 22, 1064 20 of 22

Table A2. Granger causality test p-values.

Lag-1 Lag-2 Lag-3 Lag-4 Lag-5 Lag-6

Sentiment → Return 0.2235 0.4793 0.6106 0.1492 0.1654 0.2340
Return → Sentiment 0.2906 0.4838 0.0861 0.1299 0.0028 0.0047

Appendix C
We discritize both return and sentiment into 3 partitions, i.e.

−1,

 x (t) < µ − d
L(t) = 0, µ − d ≤ x (t) ≤ µ + d .


1, x (t) > µ + d

in which µ is the mean of the data and d is the threshold for partition.
The equal probability means p( L = −1) = p( L = 0) = p( L = 1) = 13 . However, if the data
is asymmetric, the results would be diverged. Hence, the problem is to minimize the divergence
of distribution. We use the Kullback-Leibler divergence
 
P( x )
DKL ( P k Q) = ∑ P( x ) log
Q( x )
.
x ∈X

in which P( x ) is our partition results and Q( x ) is the equal probability density of that has the same
probability 13 for each partition. The optimization problem is to find the d that minimize the distance
DKL ( P k Q).
In fact, both return and sentiment data are almost symmetrical. We set the initial value of d as the
2
3 quantile of the data so that the optimization converges fast. The results are in Table A3.

Table A3. Equal probability partition results.

µ d DKL (P k Q)
Return 0.0 0.000631 0.00046
Sentiment 0.05 0.029146 0.0025

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