You have to use the ArcaOS tool to create your installation USB stick, on OS/2, the USB stack is loaded late in the boot process so can't load an ISO from the stick, instead it creates a ram disk, boots from that and then it loads the ISO.
On your ArcaOS 5.07 install, double click the ISO and mount it, then switch to the drive letter you gave it and go to the AOSBOOT directory and read the txt file and then run aosboot.cmd with the stick inserted. The command is something like,
aosboot Q: C:\downloads\ArcaOS-5.1.iso
Adjust drive letters and path as needed.