Morning Update: Dow Theory

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 indices. The theory holds that the Dow Transports should lead a rally in the Dow Industrials, since an improving manufacturing sector would require addition shipping volume, whether via boat, train, or air. Over 100 years later this is still a valid theory and is closely followed by many traders. Last week we saw the Dow Transports and the Dow Industrials close at new 52-weeks high, which has one option trader concluding that this rally will continue.

One of the top weightings in the Dow Transportation Index is Union Pacific, and this morning someone bought 100 August 160 calls for $2.95 with the stock at 152.83. This is $29,500 bet that UNP will be above 162.50, 6.3% higher, by August expiration.

The rally in the transports has been driven primarily by rails. The reason is two-fold. First, oil production in the Bakken is exceeding the current transportation capacity and driving demand for rail tankers up. The other 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, along with Berkshire’s BNSF, are the two major players in the western plains and have the most to gain from demand continuing to grow.

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% in this case because of the low volatility in the market, and the upside is unlimited should the market continue its march higher.