How to trade the oil market right now

Oil prices dropped 36 percent during the fourth quarter of 2015 and the first quarter of 2016, only to rebound back to roughly $53 just six months later. More recently, oil dropped 23 percent only to rebound back to nearly $50 again. With all the up and down volatility, traders have been eyeing the $45 mark as fair value for oil where supply meets demand.

With oil above $45, traders begin to focus on the Federal Reserve tightening, a stronger dollar, potential weaker demand globally and oil producers turning on the spigots - all the things that would be a reason to sell oil. With oil below $45, the reasons to buy oil surround the talks about OPEC production cuts and Chinese demand picking up. So the question is when does oil break the range and pick a direction, or is it as simple as buy crude below $44 and sell above $46?

To determine whether a breakout can occur, it's important to first get a read on how oil has moved in relation to the economy and if such economic conditions could push oil in one given direction out of its range. Currently, the U.S. economy has been most influenced by outsized moves in the price of gold, consumer prices, and M2 money supply (by the way, the Fed is still printing money according to the graph below) over the last year while corporate bond yields continue to fall.

Part of the reason oil has been stuck in the mud around $45 is that none of the aforementioned factors, other than falling corporate high yield bonds have really been correlated to any of the big oil names price direction one way or the other. Let's look at a stock like Exxon Mobil (XOM), a stock highly correlated with oil. We used our analytical partners, C4cast.com, to run their Economy Matters report to score the stock.

Although the Eta Price predicts XOM to move higher to $94 per share, XOM and oil have been most strongly influenced by the unemployment rate falling. Yes, unemployment rates are down but not really moving significantly lower. With the Federal Reserve now looking to raise rates to curb employment rates, it might also be difficult to see XOM move higher to that $94. However, the important takeaway is that it is critical to see some strong unemployment data in the U.S. in order to see oil move above $50 per barrel, otherwise oil is likely to remain range bound.

The one last area to watch for a breakout is to keep an eye on the oil volatility index, OVX. The CBOE Crude Oil ETF Volatility Index ("Oil VIX", Ticker - OVX) measures the market's expectation of 30-day volatility of crude oil prices by applying the VIX® methodology to United States Oil Fund, LP (Ticker - USO) options spanning a wide range of strike prices, according to the CBOE. Thus, the index will indicate traders' expectations for volatility over the next 30 days.

Oil volatility has been on a steady decline for over six months now which shows that traders believe oil's range bound price is here to stay despite the daily moves still being greater than three years ago based on where volatility was back then. One area of the chart to watch is 45 in the OVX. A rise above that level would show option traders bidding up volatility, and with increased volatility, one may see a price breakout either up or down out of the $40 to $50 range.

Until a change in volatility or econometrics occurs, I like selling puts single stock oil equity names (I'm short Huntsman Corp. puts) when oil drops below $45, and I like selling calls in USO or Crude Oil futures options when oil is above $45.

Commentary by Brian Stutland, chief investment officer, Equity Armor Investments. Follow him on Twitter @BrianStutland.

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