To understand how short selling works, it’s valuable to watch the movie Trading Places.

Let me explain the final scenes of this movie that’s all about making money out of short selling.

Tech stocks have been under pressure here and in the US of late and they copped another smacking on Wall Street overnight. This comes as a local hedge fund manager explains why these very good companies are being targeted by stock players who make money when share prices fall!

The AFR’s Gus McCubbing told us about Dave Allen of Plato Asset Management, who has shorted the likes of Catapult, DroneShield and data centre operator NextDC.

And recent months, market darlings such as Xero, WiseTech and Zip have been sold off big time.

While this has led the likes of yours truly to look at some of these businesses and argue that they look like good value for the long-term investor, Allen has rattled my confidence a little.

In contrast, the analysts are on my side, with the tech stocks that I think will come good. And here’s a quick snapshot of their views on some of these tech companies:

1. NextDC: six out of six analysts surveyed on FNArena like the company and see a 6.1 rise ahead.
2. Xero: six out of six give the company the thumbs up, with a consensus rise of 85.9%.
3. ZIP: it too has six out of six supporters and a gain of 53.6% is predicted.

On Allen’s other shorted plays i.e., Catapult Sports and DroneShield, the tipped gains were 57.1% and 18.4% respectively.

While I don’t like these two companies for other reasons, the likes of NextDC and Xero do look like good long-term plays, even if Allen is right in the short term. And that’s an important lesson for inexperienced stock players.

Recently, the shorters were anti-lithium companies. They were right for a time until they weren’t, as the chart shows.

As one story (headlined in the AFR) on this bounce back of PLS said: “Hedge funds get toasted after lithium spike sends PLS soaring.”

For those who don’t understand short selling, go and watch the movie with Eddie Murphy called Trading Places.

While many people have loved this film, they didn’t understand how Billy (Eddie Murphy) and Louis (Dan Ackroyd) were able to outsmart the market savvy Duke brothers and render them poor. The process was short selling.

Billy and Louis gained the report of frozen concentrated orange juice (FCOJ) supply, which was a normal harvest. They doctored it for the Dukes to say that it was poor harvest. This would mean demand would be greater than supply, so the Dukes expected the price of FCOJ to rise. Because of this, they instructed their ‘man in the pit’ to buy to a high level, knowing they would make a profit on a rising price.

However, knowing the harvest was OK, Billy and Louis sold contracts at the rising prices, even though they didn’t own any FCOJ.

When the report was released saying it was a normal harvest, buyers like the Dukes were desperate to get out or sell their contracts at the highest price possible as the price fell earthwards.

Billy and Louis were able to be the only buyers and they did this at lower and lower prices.

They sold at high prices and bought contracts to meet those sales obligations at really low prices, making a big profit.

The textbooks tell us that short selling happens this way:

1. A hedge fund is a short seller that ‘borrows’ the shares of other people or funds, which they think will fall in value.
2. If they’re right, they buy them at a lower price and give the shares back to the lender, which they got at a lower price.
3. Why does the lender of the shares do this? First, the short seller pays a fee to ‘use’ these shares. Second, the lender might think the short seller is wrong and the price won’t fall. That said, if the short seller is right, it could hurt the portfolio value of the lender.

While Allen and his cohort might be right for some time, eventually good companies such as Xero and NextDC are bound to make comebacks. I love buying quality outfits when the market hates them.

The two qualities worth having with stocks is patience and time on your side.