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Cryptopsychology and Bitcoin Mining

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In December of 2017, Bitcoin reached its highest price ever at $19,783. The year of 2017 was a wild ride because Bitcoin started that year at around $1,000. Investors who bought Bitcoin at the beginning of 2017 and sold it at its peak made nearly twenty times their investment. However, during 2018, the value of Bitcoin fell 73%. Even after the downturn in 2018, investors still would have made over 500% if they bought Bitcoin at the beginning of 2017 and held it for two years. During 2019, Bitcoin values recovered by an 85% increase. At the end of 2019, Bitcoin traded at around $6,500. For the same period, the S&P 500 gained 43%, which is a spectacular return for the stock market. Nevertheless, Bitcoin outperformed the S&P 500.

Volatility

In most commodities, the interplay between supply and demand influences volatility. However, with Bitcoin, the supply is not a major factor since it is already limited and predictable. Over time, the supply of bitcoins is steadily increased. Ultimately, the Bitcoin supply has a limit, as part of the Bitcoin design, which is 21 million bitcoins. The number of bitcoins will hit this limit sometime in 2140. Therefore, supply that is predictable and limited is not a major influence on the volatility in the price of Bitcoins.

Most of the demand for Bitcoin comes from investment attractiveness rather than any increased utility. While bitcoins are useful for some purchasing transactions, mainstream consumers are not using Bitcoin in massive amounts to make purchases. The main phenomenon driving the volatility and setting the value of Bitcoins is investor sentiment about Bitcoin in relation to other assets, especially fiat money. Human psychology plays an extremely important role in determining the Bitcoin value. The price of Bitcoin reflects the total of all the fears and speculations of all Bitcoin investors.

Predicting Bitcoin Prices

Attempting to identify the correlation between human psychology and the ups and downs of market cycles is a part of the many analysis efforts trying to predict Bitcoin values. For those creating Bitcoins through mining efforts, the price of Bitcoin is a major factor of whether those efforts will be profitable.

Bitcoin is a strange asset in that the cost to make a Bitcoin through mining has little relationship to its value. It is easy to determine the cost of mining Bitcoin, which is achievable using sophisticated computers and low-cost electrical power in a colocation facility designed specifically for Bitcoin mining. The cost variable is very predictable. What is not predictable is the value of the bitcoins created. If Bitcoin value suddenly drops by half due to extreme price volatility, the Bitcoin mining operations may nearly all become unprofitable. Alternatively, if the market price of Bitcoin goes up substantially, this makes mining more profitable.

The challenge for Bitcoin miners is staying in the mining game for enough time to benefit from the up cycles while also having the stamina and financial strength to withstand the down cycles. There are two major groups of Bitcoin miners, categorized as “retail” miners/investors and “institutional” miners/investors. Retail miners generally have fewer than 100 ASIC mining computers while institutional miners normally have more than 100 ASIC miners.

Understanding Market Psychology

The Bitcoin market, like many other markets, goes through distinct phases as the value of Bitcoin fluctuates. The Bitcoin value decreases until the market hits its “bottom” and then rises again until the market eventually hits its “top”. Institutional investors may be clever enough to make the contrarian move and buy Bitcoin when the market price is at or near its bottom. Retail investors rarely do this. The old saying is these markets are not a place where investors buy things that are on sale. Retail investors have a tendency to get excited and to buy Bitcoin when the price of Bitcoin is going up and then sell in a kind of panic mode when the price of Bitcoin is falling. Therefore, this retail-investing trend has a tendency to increase the volatility in the marketplace.

Prospect Theory

Prospect theory is one way to explain market imbalances. Nobel Prize winners Daniel Kahneman and Amos Tversky developed prospect theory in the late 1970s. It challenged the rational thinking mindset of logically-determined outcomes. Instead, prospect theory says that investors make decisions based on irrational expectations of profits or losses. Irrational decision-making is more prevalent in extreme market conditions. This explains why retail investors are usually on the losing side of the equation. Retail investors tend to increase investments when the value of Bitcoin is high and going up. That is precisely when institutional investors take profits by selling Bitcoin.

The reverse happens in a depressed market when the Bitcoin price is going down. During this period, institutional investors tend to accumulate positions in Bitcoin and retail investors tend to sell. Retail investors do not see downward price movement in Bitcoin as a buying opportunity. A lower Bitcoin price causes pessimism. It is a signal that they should sell or potentially they will lose even more.

The Impact on Bitcoin Miners

When Bitcoin prices went up dramatically during 2017, the Bitcoin mining hardware prices increased as well. Prices for Bitcoin mining equipment peaked at the end of 2017 and the beginning of 2018. All during 2019, the prices for Bitcoin mining equipment fell as many retail miners stopped mining Bitcoin. Institutional miners increased their purchase of Bitcoin mining equipment when the prices fell, in anticipation of another bull market. Valuable used equipment sold for steeply discounted prices due to failed mining operations that were not sustainable, when the price of Bitcoin went down.

Summary

Serious Bitcoin miners should maximize their equipment purchases when the market conditions are best and Bitcoin prices are low. Then, when the upturn cycle begins, institutional-style investors are well-positioned to increase their mining operations with colocation and hosted mining at cost-efficient colocation centers, in response to a new bull market.

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