Event risk is a fact-of-life for investors. Whether it’s a tweet from the White House or a mine disaster, the outlook for a stock can change in an instant. While many market-changing events come from nowhere, there are scheduled events that can dramatically affect a share price. The earnings reporting season is a case in point.

In the company reporting season A2 Milk revealed a 47% lift in profits for its full year. Management delivered a positive outlook, based largely on expansion plans in China and the US. Yet the stock price closed down more than 12% on that day. What went wrong?

While analysts will argue the point, two factors likely drove the stock price plunge. The first was a rise in the lead up to the results announcement that pushed A2 Milk shares towards all-time highs. The second was heightened expectations. The consensus estimate was profit growth closer to 50%. Beating or missing forecasts is a key driver of immediate reactions to company reports.

Investor responses to potential post-result volatility depends on their individual circumstances and approach. Some investors take the long view, depending on time in the market for investing success, and ignoring short-term fluctuations. This may mean greeting dramatic events like the A2 Milk plunge with a shrug of the shoulders, and sticking to the long-term plan.

However for active investors, the risk averse, and those with concentrated holdings in a single stock, there are alternatives. Buying put options is a possibility, although they are only available on the top 72 Australian stocks. Short-selling physical stock, is also possible, although it’s often a cumbersome and expensive procedure more suited to larger, sophisticated investors.

Another alternative is hedging a shareholding with Contracts for Difference (CFDs). Share CFDs generally move in lock step with the underlying share. A CFD trade can be opened by selling first, and the customer determines the size of the position. This means a shareholder can exactly hedge their shareholding. CFDs that may be short-sold are available over more than 300 Australian stocks.

An investor that owns 10,000 XYZ shares and is concerned about a share price drop after an announcement may establish an account with a CFD provider. In the lead up to the company report the investor opens a position by selling 10,000 XYZ CFDs. The price at which the CFD trade is executed is “locked in”.

If XYZ does fall, losses on the shareholding are offset by gains on the sold CFD position. It’s important to note that this also means that the shareholder will not benefit from a post-result XYZ rally. Any gains on the rise in XYZ shares are neutralised by losses on the sold CFD position.

The strategy reduces the market risk of holding a share (to zero when executed properly), but there are other risks and costs that investors must consider.

A key risk relates to the margin required to hold a CFD position. Establishing a long or short position in CFDs requires an initial margin. This is usually in the range of 5% to 20%, depending on the size and liquidity of the stock, making CFDs a more capital efficient form of hedge.

However this margin must be maintained. The CFD position is marked-to-market in real time while the share market is open. As the CFD position moves into profit, margin is released. If the CFD exposure moves into loss, margin requirements increase, and there must be sufficient funds in the account to meet the increased requirements. Most CFD providers will automatically close a position where there is not enough cash in the account to meet the margin needs. This is a protection against inordinate loss, but could be frustrating where the CFD position is hedging physical holdings.

Consider a worst-case scenario. The company report is complex. The intitial share market reaction is positive and the stock lifts 10%. The investor is not paying attention, and there is not enough cash in the CFD account to maintain the position. The short CFD position is automatically closed. Then a market-leading analyst takes a very negative view, and the stock plummets. The investor could have a loss on both the shares and the CFDS.

Investors considering a short CFD hedge of share positions need to understand how possible share price changes will affect the margin required, and be alert for substantial share price moves.

Naturally there are costs involved in establishing the CFD position. Brokerage is charged. Investors might consider brokerage rates of 0 10% or less a lower price to pay when there is potential for 10% plus moves in the stock. There are holding costs, although if the CFD position is open for just a few days these are likely immaterial. Investors should also be aware that if a short CFD position is held over an ex-dividend date the account is charged the cash value of the dividend, but the lag between profits announcements and ex-dividend dates means there is usually plenty of time to lift the hedge.

Tax considerations are another important factor. These are dependent on individual circumstances. Investors considering hedging event risk in reporting season should ensure they understand the risks and implications, and, if unsure, seek independent advice.