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The Theory Backing Up the Dow Rally

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Kevin Clark

It's an old theory with a timeless lesson—and lately, it's been telling us that this rally is strong.

Dow Theory, developed by Charles H. Dow himself in the late 1800s, holds that the strength of a rally can be determined by the relative strength of stock indexes. The theory is that the Dow Transports should lead a rally in the Dow Jones industrial average, since an improving manufacturing sector would require additional shipping volume, whether via boat, train or air.

More than 100 years later, this is still a valid theory that is closely followed by many traders. Last week, we saw the Dow Transports and the Dow Industrials close at new 52-week highs, which has one option trader concluding that this rally will continue.

One of the top weightings in the Dow transportation average is Union Pacific, and on Monday morning, someone bought 100 August 160-strike calls for $2.95 with the stock at $152.83. This is $29,500 bet that UNP will be above $162.50, or 6.3 percent higher, by August expiration.

The rally in the Dow Transports has been driven primarily by rails. The reason for this is twofold. First, oil production in the Bakken formation is exceeding the current transportation capacity, and driving up demand for rail tankers.

The second reason is that crop production is slowing, shifting west and away from rivers, which have traditionally carried the bulk of crops to market. Union Pacific and Berkshire Hathaway's BNSF Railway are the two major players in the western plains, and they have the most to gain from a continuing growth in demand.

In terms of the general stock market, however, this has been one of the most hated rallies in memory, and investors who are having a hard time buying into this market at all-time highs should consider buying calls like this trader did.

Downside risk is limited to the premium paid, which is only 1.8 percent in this case because of the low volatility in the market. The upside, meanwhile, is unlimited, so there will be a nice payoff if the market continues to march higher.

Disclosures: None on United Pacific, but Stutland does have bullish positions on the S&P 500.

Brian Stutland is managing member of Stutland Equities and a contributor to CNBC's "Options Action." Follow him on Twitter: @BrianStutland