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How to Play This Range-Bound Oil Market

NEW YORK ( TheStreet) -- We are seeing a good example of a range-bound market in oil.

As of this writing, front month crude oil futures are down over $3 per barrel at $88.71. Going back to mid-July, the November futures have been in a trading range on the daily charts from about $88 per barrel on the bottom side to just over $100 on the top side. Looking at the weekly chart, the market appears to be comfortable trading from about $80 on the low side to $110 on the high side. In my opinion, this range-bound activity is likely to continue into the new year.

Working for the oil bulls is the Fed, which is attempting to force risk-taking through additional bond buying. Also keeping a floor under oil prices is the continued unrest in the Middle East. When I look at the headlines on a daily basis, it seems the likelihood of an Israeli strike on Iran is increasing. Not good. A strike could cause a sudden and dramatic increase in oil prices. Although the world could handle this situation from a supply standpoint, fear would be pervasive and easily drive oil prices over $100.

Working against the oil bulls is good old-fashioned supply and demand. The oil market remains well-supplied, and although the economy is growing, it is doing so at a snail's pace. Unfortunately for the oil bulls, it seems that supply continues to increase at a faster clip than demand. China is becoming more of a concern as well, as demonstrated by the latest purchasing manager's index growing at the weakest pace since March 2011. With a fall off in Chinese demand, oil becomes vulnerable to downside pressure.

The other major factor, as I see it, that is keeping a lid on the oil bulls is the threat of a release from the SPR (Strategic Petroleum Reserve). Let's keep in mind that this is an election year, and we do not like getting gouged at the pump. Should oil begin to trade above the $100 mark, the chances of a release will increase. So now that I have laid out some of the basic reasons I feel this market will continue to be range-bound, what are some ways to try to capitalize on it?

Here is a simple way to attempt to take advantage of the situation. Simply play the range using short option strategies. One can look to be a deep out-of-the-money put-seller on large declines in oil, and one can look to sell deep out-of-the-money calls on rallies.

Crude oil volatility is something that you definitely want to pay attention to. In order to tilt the odds in your favor as much as possible, you ideally want to sell options that are theoretically overpriced and buy options that are theoretically underpriced. One simple tool I use to monitor volatility in the oil market is the OVX.

The OVX is a CBOE product that measures the market's expectation of 30-day volatility by applying the same methodology used to calculate the VIX and applying it to the United States Oil Fund (USO). This index has been fairly range-bound as well, trading from approximately the 30 level on the bottom to the 40 level on the top.

There are several ways to use this index, such as buying options when it tests the lows, and selling options when it tests the high end of the range. In monitoring option volatility, you will increase your odds of success.

Trades can be constructed in many different ways, including selling naked calls and puts, to selling limited risk call-and-put spreads, to more complex strategies. If you would like to learn more about market-neutral trading, or how to potentially play a range bound market, feel free to contact me.

In my experience, markets spend the majority of their time range-bound, and if you do not have a weapon in your trading arsenal, you are missing too many potential money-making opportunities. Please note today is Oct. 3, and any trade information is based on the most recent data.

Please note: Futures and options trading is inherently risky and isn't suitable for all investors. Past performance isn't indicative of future results. Stop-loss orders meant to limit losses may not be effective because market conditions may make it impossible to execute such orders.
Matt Zeman is a trader at Kingsview Financial. He began his trading career as a runner in the grain pits at the Chicago Board of Trade before becoming an arbitrage clerk. Eventually he started trading equity options and stocks. Matt now is a full-time futures broker. He has been a frequent guest on CNBC, Fox and Bloomberg, and provides his views on the stock, bond and futures markets for financial media including Dow Jones, the L.A. Times and The Associated Press. Matt is a member of the Chicago Board of Trade, and carries series 3, 7 and 66 licenses.

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