LONDON  - How does an oil trader play the market when Iran threatens to shut the Strait of Hormuz and strangle Middle East oil supplies?

"Buy!" some would say.

But "Sell!" could come from cooler heads, the grizzled veterans who can cut through the bellicose rhetoric and who remember the 1980s Gulf "tanker war" in the Iran-Iraq conflict.

Iran did not block the Strait then, nor during decades of tensions with the West.

"There's a lot of rhetoric," said Rob Montefusco, trader at Sucden Financial. "Some people who have been around a long time are saying 'we've seen it all before', so they are using the recent price spikes as an opportunity to sell." Back in the 1980s, the United States, with its mighty Fifth Fleet stationed in the region, threatened to go to war if the strait was closed.

"We've seen this movie before," said Cliff Kupchan, an Iran analyst at the Eurasia Group. "Neither side wants a war. A lot of this rhetoric is overstated." Iran is OPEC's second biggest exporter, but the prospect of the loss of a chunk of supply seems to be sparking fewer and fewer doomsday predictions that oil prices will soar to $200 a barrel, very common just a few months ago.

Benchmark Brent oil prices have fluctuated around $110 a barrel, despite rising fears about Iranian oil supply as a result of tensions with the West over Tehran's nuclear programme.

Prices have been capped by fears of a steep downturn in euro zone economies, which could upset the recovery around the world and crush demand for crude, and by expectations that OPEC leader Saudi Arabia's will fill the supply gap as it did last year when Libya's oil was lost.

Doing without Libyan production in 2011, although less than half that of Iran, with only a manageable price spike gave the oil market a taste of coping with a supply shock.

The most serious fears debated at oil trading desks include the possibility of Iran mining the straits, attacking ships as it did during the Iran-Iraq war, or challenging the legality of the passage of some vessels through its territorial waters.

"The Iranians have raised the rhetoric stakes hugely in the last two weeks, but for them the game has changed," said Philip Wiper from oil brokerage PVM. "One could even envisage the Iranians putting a few mines in the Strait with little effort, and maximum inconvenience for a few days while the US navy clears them up," he added. But bracing for even the second or third worse case scenarios may not be a feasible trading position for now.

"Everyone loves the idea of being long oil into an Iran situation but I can't just sit on the bid hoping that something will kick off. So to take it seriously, something serious needs to happen," a veteran products trader said.

"Until then it's something on the sidelines. Any rallies we are seeing on the news is purely day trading, and it may reverse just as quickly as it rallies."

Nor has there been much evidence of big hedge funds or speculators rushing to the options market to buy cheap out-of-the-money calls in order to profit from a price spike.

A call owner has the right to buy crude at a preset strike price. Calls begin to pay off when oil rises and when rising price volatility increases the odds the option will expire in the money.

CBOE's oil volatility index has eased for the past three days, trading near its lowest since early August. Open interest in June $140 strike calls jumped by by more than 7 million barrels this week, but other key contracts for both Dec 2012 and Dec 2013 were all but unchanged, suggesting no great rush to buy upside insurance. Unusually, there's been a bias toward trading "puts", which confer the right to sell oil at a predetermined price if the market falls, a bearish trade.

"As the Iranian news has made its way into the market over the last few weeks, I've seen a greater influx of call and put buying than I normally see at this time of year, with an emphasis on the put side," said Anthony Rosado, options broker at GA Global Markets in New York.

Late December was a lesson in the ups and downs of headline trading on Iran. Oil prices jumped by around 2 per cent when Iran threatened to block Hormuz but pared most gains the next day after the US Fifth Fleet said it would not allow any disruption to oil flows.

On Friday, oil barely moved when Iran said it would hold new naval exercises in the Strait.

The US Fifth Fleet keeps one or two aircraft carrier battle groups either in the Gulf or within striking distance in the Indian Ocean.

"If Iran prohibits the US warships from transiting in their territorial waters this is not by itself a case of "casus belli" to retaliate militarily on Iran. Furthermore, the US warships could still transit the strait... on the Omani side," said Olivier Jakob from Petromatrix consultancy.

Traders said that a full loss of Iranian oil would no doubt trigger a major spike in oil prices as Saudi Arabia would be forced to use all its spare output capacity, a crucial safety cushion for oil markets. But the European Union and the United States appear to be taking a calculated risk approach by planning a gradual phase out of Iranian oil which might take months.

The EU is close to imposing sanctions on Iranian oil but with some exceptions while the United States, which has banned it since 1979, is talking to China, Japan and South Korea to persuade them to reduce purchases from Tehran.

Jakob said he believed Iran will continue the soft escalation to keep the oil prices high to increase revenues amid what looks like an inevitable loss of exports volumes.

"I don't see any serious threat to supply even if there is a full blown war. It will last for two weeks during which the US will kick the hell out of Iran and make sure all is fine in the Strait of Hormuz," said a veteran trader with oil majors and trading houses.

In the event of a big stoppage the consuming nations' International Energy Agency would very likely release emergency government stocks to tame prices, as it did in June last year when Libyan output was lost.