10% Annual Alpha? Why Pair Trades Make Sense When The Market Is Volatile

• A great way to generate alpha in an uncertain and volatile market could be pair trades.
• Deutsche Bank’s pair trades model generates 10 percent annual alpha during backtesting.
• Deutsche Bank’s model identifies divergence between highly-correlated, supply chain-linked pairs of stocks.

In an uncertain and volatile market, pair trades can be a trader’s best friend. Deutsche Bank analyst George Zhao discusses the benefits of pair trades in a new report and includes some stocks that could potentially make solid pairs.

Hedge Against Uncertainty

Concern over recent global economic events in China and elsewhere has led to increasing uncertainty and volatility. However, Deutsche Bank’s pair trading model has demonstrated outperformance during past periods of high market volatility.

About The Model

Deutsche Bank’s model incorporates supply chain relationships to select stocks that are strongly correlated, demonstrate supply chain linkage, operate in the same industry and share similar risk profiles. The model looks for divergence from the correlation in paired names. Once the divergence ratio has reached two standard deviations of the mean and then begins to revert, the model signals a trade entry point.

A trade is exited when the divergence ratio either reverts to the mean or the trade remains open for nine months.

“The annualized alpha for our pairs trading model, based on the backtesting, is above 10%,” Zhao claimed in the note.

Potential Trades

The report doesn’t include suggested pair trades, but it does include top buy and sell ideas. Although those interested in gaining access to the pair trading model described above must contact Deutsche Bank for more information, here are three potential pair trades that involve buy-rated and sell-rated stocks on Deutsche Bank's lists.

1. Buy: Enterprise Financial Services Corp EFSC

Sell: RCS Capital Corp RCAP

2. Buy: Chemed Corp CHE

Sell: XOMA Corp XOMA

3. Buy: Brown-Forman Corp (NYSE: BF-B)

Sell: Fairway Group Holdings Corp FWM

Disclosure: the author holds no position in the stocks mentioned.