Anatomy of the Bitcoin Crash

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At the start of the second week of April 2013, the value of the digital currency Bitcoin rose to almost $260.

Then over the following few days the Bitcoin price fell at one point to below $60.

Since then it’s recovered somewhat and at the time of writing Bitcoin is fluctuating somewhere below the $100 mark.

This means the digital currency lost some 70% of it’s value in just a few days.

That’s a collapse of almost double that seen on stock market in the Wall Street Crash of the late 1920s.

Anatomy of the Bitcoin Crash

Before the crash, many people were talking about Bitcoin rising exponentially in value, even up into the thousands of Dollars. It seemed to some that the value appreciation was now well and truly on it’s way.

Then came the collapse.

So how do we explain these dramatic events?

First, lets take a brief look at what Bitcoin is.

What is Bitcoin?

Bitcoin is a new digital currency created about 5 years ago by a computer programmer with the pseudonym of Satoshi Nakamoto.

Bitcoin is an open source system, which means the computer program code is freely available for anyone to examine. It’s not owned by any one person, company or other organisation. Technically, the Bitcoin system itself is considered to be highly secure, well programmed and resiliant.

Bitcoins exist only in the Internet, and they’re passed between participating users via their computers.

You Don’t Need a Bank to Transfer Bitcoins

One of the plus points about Bitcoin is that you don’t need to use a bank to transfer Bitcoins, nor hold the funds. Transfers are taken care of the Bitcoin software itself, which is decentralised and operates on a peer-to-peer basis.

This means there’s no central server that Bitcoins have to pass through and no central organisation that runs Bitcoin. The whole system runs itself via the software system.

It’s rather like peer-to-peer mp3 file sharing systems. In fact, you could describe Bitcoin as the Napster of the financial world.

There Are (almost) No Fees for Bitcoin Transfers

And because transfers are made directly between people’s computers via the Internet, there’s no need for any bank charges or bank delays.

No more having to wait “three to five working days” for a payment to be processed. No “overseas transaction charges” either, when you send money to a recipient in another country. For Bitcoin it makes no difference whether the payment recipient is on the other side of the world or next door to you. The Bitcoin software simply levies a small nominal fee which is distributed automatically to Bitcoin miners.

Bitcoins are Mined By Computers

Bitcoins are created by computers carrying out calculations, in a process known as “mining”.

In theory anyone is free to install the mining software and begin mining their own Bitcoins. In practice though, as I discovered myself, it’s not feasible to try and mine Bitcoins with the average PC. To mine Bitcoins profitably requires powerful specialist computer equipment which has to run around the clock for long periods.

After doing my calculations, I realised that trying to mine Bitcoins with my computer would be a losing proposition. It would cost far more in electricity and wear and tear to my computer (Bitcoin mining is very processer intensive) than it would generate for me in newly minted Bitcoins.

But that’s actually just as well for Bitcoin. If anyone could easily start generating Bitcoins, then the currency would soon lose it’s value.

Bitcoin Naturally Appreciates in Value

This difficulty in creating Bitcoins is intentional. The supply of Bitcoin is strictly limited by the algorithm of the system. Only around 21 million Bitcoins can ever be created. Right now we’re reached the half way mark of this supply.

This prevents the currency from ever becoming inflated and devalued, which is a big plus point for Bitcoin. In this way the currency should not only retain it’s value, but will also be able to appreciate substantially further over time.

This is completely different to the existing central bank paper currencies of national governments, which all experience gradual depreciation in value over the years.

Since the supply of Bitcoins is strictly limited and can’t be inflated by central banks or governments to suit their policies, the Bitcoin currency will always be able to maintain and increase it’s value.

In that sense, Bitcoin is rather like a digital version of gold.

You can also use Bitcoin to make transactions, provided the business participates in the system. Most businesses don’t acccept Bitcoin at present, but the number is increasing fast.

So, with all these advantages, how come the value of Bitcoin suddenly crashed in April 2013?

Why Did Bitcoin Suddenly Crash?

Some people claim the crash was caused by “malfunctioning exchanges”, or ddos (distributed denial of service) hacker attacks on the exchange trading servers which exchange paper currencies such as the Dollar and the Euro into Bitcoin.

I don’t agree with this view.

There were definitely ddos attacks going on against the exchange servers, (there are ddos attack attempts occurring almost continuously nowadays against many servers), but I think this would only have had a minor effect on the Bitcoin crash.

I think the real cause was simply the parabolic rise in the value of Bitcoin that took place through March and into April.

Even if the exchanges had still been open, I think it highly likely we would be seeing a crash either at the time we did, or else sometime very soon. The price just went too high too fast. What we saw was a sudden frenzy of buying and speculation. When that happens there has to be a correction.

You don’t need malfunctioning exchanges or even ddos attacks or overloaded exchange webservers to set off a sudden move down. If the price has risen too high, then almost anything can set off a sudden move in the opposite direction.

A lot of stampede selling is mostly just fear and herd mentality. Once a sharp move downward occurs large numbers of people take heed and follow and sell.

Especially if they’ve just come into the market to speculate and not to buy and hold or use Bitcoin for transactions. This category of buyers will sell as soon as there’s a clear downward sign.

I get the impression a lot of people saw Bitcoin as a stock or get-rich-quick scheme. Why else would it crash so suddenly if people were happy to hold it?

Let’s take a look at the extraordinary growth in the value of Bitcoin in recent months.

Bitcoin’s Extraordinary Rise in Value since January 2013

From the start of 2013 through to mid March, the value of Bitcoin on the exchanges rose steadily from around $15 up to $50.

This is an extraordinary increase in value in just three months, an increase of over 300%.

But more was to come.

Interest and awareness of Bitcoin started to increase as the mainstream media began to focus on the currency and it’s remarkable sudden rise in value.

Then suddenly, the Bitcoin price really took off – and no longer exponentially, but parabolically.

In other words, the value  of Bitcoin went right up almost vertically within the space of a few weeks. From $50 to $260. That’s a further rise, on top of the 300% rise we’d already just seen, of over 400%.

Or to put it another way, Bitcoin had risen in price from $15 at the start of the year to $260: an increase in value of over 1600% in just 3 months, which is spectacular by any measure.

Before suddenly crashing down in just a few days.

Parabolic Price Rises Always Crash

This sudden second stage price explosion from $50 to $260 is what stock and Forex market analysts call a parabolic chart pattern.

Parabolic price movements are inherently unstable and they always crash. Profits can be made by those who recognize the movement and who buy at the early stage, ie at the base, and provided that they then exit before the top and the subsequent very fast crash.

Parabolic growth in the value of an asset is not a long term sustainable price situation. In other words, it’s a bubble. The asset is overvalued and so the price must come down.

If you extrapolate the three month trend line of Bitcoin for the period January to March 2013, the trend is upwards towards the $100 point.  Anything above that trend line  in the interim will be likely to be overpriced and highly volatile.

Why Were People Buying Bitcoin?

The Bitcoin exchanges, the main one of which is Mt.Gox, have experienced an exponential rise in the number of people suddenly wanting to open trading accounts.

Most of these new entrants were probably completely new to Bitcoin. They liked the idea of a currency that bypassed the banks and the central banks and governments.

There is also some usage of Bitcoin for money laundering and purchasing drugs and for other illicit purposes. But I think this is only a small part of the trading volume. In any case, most money laundering and drug dealing is already conducted using USD, EURO and other established currencies, as it always has been.

Are people buying Bitcoins because they want to make legitimate purchases with the currency? You can now pay for such diverse items as web services, e-commerce items and in some cases pizzas.

I don’t think so. Not many people will want to use a currency for spending purposes which appreciates by such large amounts from one day or week to the next. Better to hold onto it and pay for your pizza with Dollars, Euros or Pounds instead.

What about using Bitcoin for payment transfers? This is more likely, but it will still only comprise a small proportion of the total.

This by the way is also the case with practically all the established paper Forex market trades. Currency dealers aren’t buying and selling foreign currency to finance trade or vacations, but mainly for speculative reasons.

What about people buying Bitcoins because they think it’s a good investment for the future, in other words, to “buy and hold”?

There will be some who do this. The long term prognosis for Bitcoin is generally considered to be positive. Whereas the long term outlook for the Euro and the Dollar is much more uncertain.

The greater part of the Bitcoin purchases in March and April would have been people piling in because they want to make a short term profit.

In other words, the follow the herd mentality was at work. The price is going up, so we buy. And when the price can go no further and starts to fall, so we sell. And so it crashes. Basic market dynamics.

I first discovered Bitcoin in 2011. I had a very small holding at the time, but I wasn’t convinced by the currency back then nor interested in increasing my holding in Bitcoin (I only wish I had done so – I could have been very rich by now).

The Bitcoin price also collapsed back then, rising an incredible 300,000% before crashing back down again. So what we’ve seen now is actually the second great Bitcoin crash to date.

Back to Normality for Bitcoin

Since the crash of mid April, Bitcoin has so far been relatively stable, with prices moving between a band of approximately $75 and $95. Even this is still an extremely broad price band compared to paper currencies, stocks, and many commodities.

I see this lower level as positive for the moment. It means that Bitcoin’s March Madness is over. A cold bucket of water has been thrown over the currency and we now have a degree of relative calm for the time being.

It will most probably take a few weeks or so before Bitcoin decides where it will be going from here.

Interested in Trading or Investing in Bitcoin?

In the opinion of many people, Bitcoin offers good opportunities for investment in the long term as well as trading in the short to medium term.

If you want to invest or trade in Bitcoin – in any other asset market, then I strongly recommend you take the trouble to learn how to trade professionally first. An excellent way to do this is to take a training course in asset trading.

One such course that I can recommend is David Jenyns Ultimate Trading Systems training course.

Do You Also Want to Learn How to Become a Successful Stock Market Trader?

Ultimate Trading Systems is a truly EXCELLENT training and coaching course that will get you up and running as a successful stock market trader in the shortest possible time.

Check out David Jenyns Ultimate Trading Systems training course at www.ultimate-trading-systems.com

Disclaimer and Disclosure

WARNING: The value of all investments can go down well as up. Always seek independent professional advice before making any investment decision. Never invest in any asset or scheme that you do not understand. Never invest more money than you can afford to lose.

DISCLOSURE: The author holds investments in currency and the stock market at the time of writing this article.

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