3 Tales of Wall Street Horror and What to Learn From Them

Looking to get spooked? Halloween is here, but the stock market is no stranger to scary stories any time of year.

From computer glitches sending tons of money down the drain in seconds, to companies spontaneously splitting into two heinous entities, to businesses being sucked dry like the victims in a vampire movie, there's plenty of shock value in the stock market, and these tales of woe can almost be considered modern classics with morals for wary investors.

The flash that will live in infamy
The flash crash of May 6, 2010 is one of the freakier events to have occurred in Wall Street history. It wasn't an especially good day to begin with, what with the Dow Jones Industrial Average (DJINDICES: ^DJI  ) down more than 300 points due to concern over Europe's mounting debt crisis. At 1 p.m. EDT that day, the euro dropped sharply against the dollar, as well as the Japanese yen.

Then, at 2:42 pm, the Dow plummeted 600 points lower, all within five minutes, tallying to an epic 1000 point loss for the whole day. Then, as if the whole thing was just a bad dream, within the next twenty minutes the market had made up most of the 600 points it had just fallen.

So what the heck happened? With an already fragile market, one big trade could throw the whole thing into disarray. And according to the SEC's analysis , that's exactly what happened. At 2:32 pm, a "large fundamental trader" began a program to sell $4.1 billion worth of E-Mini S&P 500 contracts "as a hedge to an existing equity position." Already a huge amount to trade, the trader then used an algorithm to trade its E-Mini S&P 500 contracts at a rate "set to 9% of the trading volume, calculated over the previous minute, but without regard to price or time."

What happened next can be likened to one tremendous game of hot potato. The buyers of the large seller were high-frequency trading firms, and they began quickly and aggressively selling what they had just received. In 14 seconds, those firms traded more than 27,000 contracts and only bought a net of 200. The combined effect of all these simultaneous sales, both from the seller and its subsequent buyers, was a 3% drop in the price of product (the E-mini contract.

From there, other computerized traders detected what was happening and shut themselves down because of the sharp drop in buying and selling, which made prices plunge even further. Trading for those contracts stopped at around 2:45 for five seconds, which allowed prices to stabilize and everything to effectively fix itself. But the emotional damage to the already manic stock-market sentiment had been done.

Wall Street's short and intense panic attack contains a useful lesson for Foolish investors. The situation is an excellent example of the importance of staying clear-eyed and level-headed and knowing exactly what your stocks are worth on your own. That way, if and when things go crazy, you'll recognize mania for what it is and be able to distance yourself from it.

The tale of the social-media life-sucker
You might remember Facebook (NASDAQ: FB  ) from a May 2012 horror story, known by many as "The Most Nightmarish IPO in Recent History." Facebook played the helpless victim in that one, as its IPO aspirations were mangled by a two-hour trading delay. However, in this telling of the tale, Facebook wears a much different hat. Let's start at the beginning.

When online gaming company Zynga (NASDAQ: ZNGA  ) debuted on Wall Street in December 2011, it seemed like the sky was the limit. The company's game portfolio, including FarmVille and Words with Friends, was sweeping the nation, and the company had a special exclusive relationship with Facebook that modified the social-media giant's terms and conditions, boosted Zynga's promotion and distribution, and was Zynga's largest source of revenue.

Even from the beginning, investors could sense that something was strange about the agreement between the two companies. When Zynga launched its own independent website in March 2012, its stock jumped more than 10% to $14.69 per share. Soon after that, thought, things started getting much, much worse.

When Facebook went public in May 2012, the debacle sent shockwaves through many a social-media company, and Zynga saw its stock plummet 7.6% the week afterward. Earnings reports revealed that Zynga gameplay was dropping just as Facebook's was rising.

The final blow came in November 2012, when Facebook ended its special agreement with Zynga, putting the gaming company at the same level as every other developer on the site. By then, Zynga's stock had been all but sucked dry -- within the last year, it has peaked at $3.93 per share, which is 73% lower than its all-time high. Now, Zynga has fallen from the top spot in social gaming as Candy Crush developer King takes the lead and more diversified gaming companies like Electronic Arts plan to cross over from console gaming to Facebook's mobile terrain and stiffen Zynga's competition even further.

The investing lesson here? Keep a keen eye on a company's allegiances -- namely, whether its relationships seem unhealthy or one-sided. Strategic business relationships can be helpful, but they can be a yellow flag when the deal is a company's biggest (or only) pipeline for funds, user visits, or what have you. If a public company doesn't look like it can stand on its own two feet without the help of another, larger business, you might want to think twice before putting your investing dollars into it.

Dr. Netflix and Mr. Quikster
In 2011, it seemed DVD and streaming-video service Netflix (NASDAQ: NFLX  ) could do no wrong. The company was doing well on the stock market, lauded for being the next big thing to revolutionize how we watch television, and in the year prior, its revenue had risen from $1.6 billion to $2.1 billion

Nobody's perfect, however, and one day Netflix concocted a new business formula and decided to test it on its hapless customers...

In July 2011, Netflix announced to investors that it was splitting apart its core businesses into two separate companies. Netflix would still provide streaming video, while its DVD-by-mail service would now be called, for some reason, Qwikster. In order to have both services, customers who were used to paying less than $10 per month would now have to pay $15.98, but the press release still had the guts to proclaim the move Netflix's "lowest price ever."

Investors reacted like a mob of angry villagers carrying torches. No one could figure out why Netflix had taken such an effective business model and so dramatically altered it (and so quickly, to boot) that it looked like a twisted, funhouse-mirror version of its former self. The company's stock tanked as a result, dropping from $295.14 in July '11 to $116 that October. Additionally, in its October 2011 quarterly earnings report, Netflix reported having lost an astounding 800,000 subscribers in a span of three months.

Netflix realized it had committed an egregious error and undertook a massive damage-control effort. CEO Reid Hastings issued a profuse apology on his blog and swept the Qwikster abomination under the rug -- and it was never heard from again. That doesn't mean everything was immediately hunky-dory, though. Netflix remains effectively split into two subscriptions, and anyone who wants both services still has to pay 60% more than they would have before -- just not with a Qwikster association.

Netflix has, of course, more than bounced back from this debacle. The company recently beat HBO in its subscriber numbers, thanks in part to wildly successful made-for-Netflix originals like House of Cards and Orange Is the New Black. Its annual revenue has risen 66.8% since 2010, and its stock is at an all-time high of $323.14.

The moral of the story here is that everybody makes mistakes now and then (sometimes really, really big ones), and even beloved companies can take a turn for the worse. And when they do, the damage my be either skin-deep or serious. So how to know whether a mistake is just a blip on the radar or cause to abandon ship?

It can seem a lot more obvious in hindsight, but in the moment, take a close look at how the company responds to the crisis. If no real changes are made, even after a stock plummets and investors revolt, then that may be a sign of incompetent management -- and that's a bigger red flag than the mistake itself. The fact that Netflix's CEO personally (if not immediately) apologized was a promising sign for the company.

A market of tricks and treats
Halloween comes and goes, but the lessons in these frightful stories can be applied any day of the year. Staying calm, even in the face of flash-crash mania, might seem impossibly hard to do in the moment, but doing your own research on the stocks you own can help quell anxiety. And when it comes to company missteps (like relying too heavily on another company or inexplicably splitting yourself in half), trying to take a step back from the mania to assess just how serious these mistakes might be is vital. The takeaway of these three stories, though, is that on Wall Street, there is extraordinary value in keeping calm and carrying on.

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