Yes, you can install windows from a USB DVD drive. I actually never install an OS from optical media any more, been using an SD card for years. DVDs are very slow compared to even modest thumb drives. Win7 installs from a USB stick in about 15 minutes, start to finish, while with a DVD that's closer to an hour.
I don't even have a DVD drive on my desktop anymore. When I need to install something from a DVD I pop the disc in my backup computer, rip the image and put that on my SD card. Tends to be faster, even with the extra steps, because you can rip DVDs totally sequentially and your drive will run faster during ripping than it would while installing.