My short thesis was based on the potential for developing technologies from obscure upstarts to steal market share from Netflix and competitor Blockbuster (BBI). I also reasoned that Comcast (CMCSA) is really the company, however hated cable companies might be from a customer service point of view, that has the greatest chance of success in the battle for the future of digital video distribution.

For any chance that Netflix stands to survive the creative destruction of innovation, the company indeed needs to be spending more money developing next generation technology for content distribution. The market’s shortsightedness is punishing the company for the one thing it should absolutely be doing to ensure long-term survival. The only other way for it to acquire the technology to survive is to buy it from technology startups that are actively trying to address the digital content distribution problem.

So although my trade is working, the reason for the stock’s drop is not what I posited. Long term, I stand by my short on Netflix and Blockbuster, their valuations are currently too high once their competitive advantages are eroded by new technologies.

With so much at stake, the future of video promises to be a most entertaining saga. Many players are trying to figure out how to navigate the shifting technological landscape. How video entertainment is created, delivered, and sold is changing with breathtaking speed. New competitors are entering the market and current leaders are scrambling to defend their turf.

Blockbuster (BBI), playing the part of copycat, will soon announce a set-top box similar to what Netflix (NFLX) unveiled at the Consumer Electronics Show earlier this year. The two companies have seen their fortunes move in opposite directions. Blockbuster’s stock has fallen about 49% over the past year while Netflix has seen a 48% rise in its stock price. I have to commend Netflix for attempting to rewrite their own game changing model. It pioneered the mail order rental model, put a very good Internet component to the ordering process, and now is trying not to fall prey to outside innovation by tackling the problem and opportunity of digitized video delivery. If creative destruction is going to happen, you might as well do it to yourself. At least the two companies are trying; laggard Movie Gallery (MOVIQ.PK) looks dead even as it attempts to exit bankruptcy.

But will any of this matter? Distributing a digital set-top box that allows Netflix and Blockbuster to deliver video over a digital network puts them squarely in competition with Comcast (CMCSA) and other large cable network operators. Comcast already has pretty good video-on-demand services and owns that relationship with the consumer. It already has millions of cable lines breaching the last-mile problem. Getting consumers to adopt newfangled digital set-top boxes will be much easier for Comcast and its cable peers than for Blockbuster and Netflix.

Investors will also have to keep an eye on the currently free and rudimentary video sharing services such as YouTube (GOOG), GoFish (GOFH.OB), and their private brethren. There are dozens of free video sharing sites that are growing quickly by allowing users to upload and share home videos, amateur content, and the equivalent of podcasts – videocasts. What I call the Age of Amateurs has taken hold of public attention but that will give way back to the professional content producers. They’re cute now, but how many skateboarding dogs and Obama Girls can we watch? As with all things social on the Internet, we will grow up. Granted, I think the future will be kind to a creative combination of the amateur and the professional. Joost, founded by the guys who brought us the popular VoIP service called Skype (EBAY), looks like a potential winner in that regard.

The challenge for these video sharing social networks will be in improving video compression software such that professional-quality video can be beamed down Internet pipes without loss of viewing quality. Companies like Sorenson Media, Fibridge, and DivX (DIVX) are all trying different approaches to solving that problem. Full disclosure: I’ve performed very preliminary, basic consulting for a Sorenson Media subsidiary. If video compression codecs can improve exponentially, Comcast, Blockbuster, and Netflix may well have to concede the future of video to the Joosts and YouTubes of the world.

Bottom Line: my bet is that Comcast wins the battle on professional video-on-demand and the video sharing sites will own the rest. I would bet against Blockbuster and Netflix in the long term. The shorts agree on this one as both Netflix and Blockbuster have tremendous numbers of shares short as a percentage of their respective floats.