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Beaten-Down Small Cap Looks Poised for a Powerful Breakout

Buying on weakness and selling on strength is the hallmark of the professional trader. While the average Joe investor attempts to buy stocks as they are climbing higher, the professional quietly waits for prices to drop in order to enter positions.

Obviously, not all declines should be bought. Sometimes a falling stock just keeps on falling until it's close to zero. Professional traders call the attempt to buy stocks that keep dropping trying to catch a falling knife. 

The question is how does one tell the difference between a falling knife and a simple pullback that should be bought? Here are three ways to help you tell:

1. Determine what caused the pullback.

If the pullback was caused by a one-time special situation, like an earnings warning, negative rumors, or even the selling of shares by an institution, this can create an opportunity to purchase shares at a discount. However, if the negative news comes in waves or something fundamental changes at the company, this could mean that prices will continue lower.

2. Watch the 200-day simple moving average.

The basic rule of thumb with the 200-day simple moving average is that shares that are in the process of dropping and are below that moving average should not be purchased. This can act as a line in the sand between buying and selling pressure. If shares are below the 200-day moving average and start to climb higher, this can be a buy signal depending on what caused the pullback.

3. Wait for the bounce.

Rather than trying to time the rebound, wait for it to start prior to buying. This is particularly critical with shares trading below their 200-day simple moving average. A bounce through a widely watched resistance level such as the 50-day or 200-day simple moving average can be a clear buy signal after a stock pulls back.

A recent example of a stock that has experienced a dramatic drop but has since bounced from the lows and appears to be setting up a powerful buying opportunity is small cap Aruba Networks (NASDAQ: ARUN).

Aruba Networks is a California-based provider of computer network access solutions for mobile enterprises. In other words, the company provides Wi-Fi connection products and services. It boasts a $1.8 billion market cap, $586 million in trailing 12-month revenue, and almost $441 million in total cash. 

Most recently, revenue for fiscal Q3 2013 grew 12% to $147.1 million from $131.9 million in the year-ago period. GAAP net loss for the quarter was $20.2 million, or $0.18 per diluted share, compared with GAAP net income of $6 million, or $0.05 per diluted share, in Q3 2012. Non-GAAP net income for Q3 was $14 million, or $0.11 per diluted share, compared with $19.4 million, or $0.16 per diluted share, in the same quarter last year. 

Following the fiscal third-quarter results, released on May 16, the stock plunged almost 30% in one day.

In addition to the earnings miss, the small cap has been under pressure from legal troubles. Law firms have filed a class-action lawsuit alleging false and misleading financial information from the company. The alleged misinformation is due to the fact that Aruba Networks did not reveal its primary competitor Cisco's (NASDAQ: CSCO) bundling advantage in the space. While I am not a lawyer and not qualified to comment on legal proceedings, this smells very speculative to me and difficult to sustain. 

It's important to note that despite the disappointing third-quarter results, gross margins remain strong and the company continues to operate effectively within its niche. So far, the stock price has agreed with my opinion. 

ARUN Stock Chart

The pullback has enabled savvy investors to buy on the bounce from the lows for almost 30% gains so far. Clearly no one knows what the future holds. Despite my bullishness on the company and skepticism about the lawsuit, anything can happen in the stock market. Always use stops and position size properly when investing. 

Recommended Trade Setup:

-- Buy ARUN on a break above its 50-day simple moving average at $16.45
-- Set stop-loss at $15
-- Set initial price target at $20.45 for a potential 24% gain in 12 months