So I've been watching bitcoin for a couple weeks, and i got a bit of my own dough into it.

Of recent everybody seems obsessed with the vast accumulation of wealth in the hands of few, and the hordes of panicky upstarts trying to get in, who might get screwed by falling prices (for instance see this lovely post

Hyperbole

Now I'm not saying that the doomsday scenario the prophets are peddling is impossible. But it's about as possible as the wonderland prophets who're hoping for a 100'0000% return.

Trojans

On a related note, yeah some trojan started targeting wallet.dat, surprise surprise. Incidentally, that the same machine you're making VISA payments from and operate your e-banking? You worried about that too? Not? Well I don't see VISA shares falling every time somebody infects himself with a keylogger.

Pricing

So I thought a fair bit about where prices are going to go, and why, and I asked a lot of people and talked this over, and after this, a few things remain that give some direction.

A price of a security (like bitcoins, or gold, stocks, fiat money etc.) is ultimately determined by supply and demand. If you understand supply and demand, you understand prices.

So an important consideration is who's bidding for bitcoins, and who's asking for a price to sell them, and what prices to these parties consider reasonable.

Buyers (bid)

This is a diverse group of people, it may include people who use the small but fledgling bitcoin economy to buy coins to pay other people in them. But by far and large, it's probably a speculation driven market, people buy bitcoins in the hopes the value will rise.

The psychology speculative buying ends up being about a zero-sum game. Somebody buys, somebody sells, the overall activity neither adds or removes coins from the market, and hence when viewed over long periods (months/years) this activity is just white-noise.

This defines the demand, and demand rises and falls with bitcoin popularity and confidence. Some week confidence may be low, some it may be high.

Sellers (ask)

This roughly falls into two camps. The speculative sellers and the miners.

Speculative selling (that is sells of coins bought earlier) is the other half of the zero-sum game, it neither adds or removes coins overall, and is hence just white noise.

Freshly minted coins (by miners) which enter the market are the real driver of supply.

The limited and small constant supply myth

Every 10 minutes 50 new bitcoins are found. That is a fact, and if it strays from that, the difficulty adjusts to keep it there. If you look at it purely from the point of view of scarcity, this would seem a small (but nearly ignorable) inflationary influence.

This however would be an over-simplification. There are substantial amounts of mined coins held by people who've been mining them for the better part of a year. They've been hoarding these coins, and commonly I'd refer to this group as bitcoinionaires. Their actually supply capacity vastly exceeds the day to day supply of fresh coins.

Since these stockpiles are the real driver of the supply, it's important to understand when the miners/bitcoinonaires will sell and when they will not.

Mining economics

The mined bitcoins where obtained by the activity you call mining. This is neither an easy nor free way to get coins. It takes energy, room, time to setup, etc. There are constant costs attached to this (paying rent and electricity) as well as recoverable costs (buying hardware to do it) and unquantifiable costs (work rendered to make it all happen).

You can think of mining as a business that has expenses and profits. In order for that business to work, the constant expenses must be covered, the recoverable expenses must be recoverable, and the work invested must be repaid.

This all leads to a fairly straightforward calculation which goes something like this: You pay around 1000$ for one 1gh/s (one gigahash per second) in hardware. Running that hardware you pay about 2-3$/day/gh in energy. If you factor in rent of some or another form, you probably pay between 1-5$/day/gh in rent. If you also factor in resale value decay of the hardware you bought, you immediately lose about 20% upon buying the hardware, and around 30%/year.

As a business you probably plan to run your miner for more then half a year, so about 50% of the hardware cost has to be recovered in a reasonable time-frame, say 3 months. Which means there's a hardware recovery calculation that you should do that factors in at about 2$/day/gh

If you sum that all up, you get a running cost of mining that is around 5-10$/day/gh.

One gigahash will get you about 1.2btc/day at current difficulty, which is at current prices somewhere around 17-20$.

It is fairly obvious that your expenses need to be lower then your profits. If they are not, what happens?

Difficulty

You may have heard about difficulty, in essence it is a constant value (for 2 weeks) that aims to keep the rate of fresh coins at about 50coins/10minutes. Obviously, the more difficult it gets, the less coins 1 gh/s will mint, and the more difficult the economy of a mining business becomes.

miner psychology

Since you can't simply acquire and sell hardware capacity on a dime (it takes weeks and months to do it), and since you will need months to recover your boot costs, miner selling is out of necessity a long-term affair.

So what can a miner do when the price of btcs falls below their operational cost?

• They can give up mining, much to the delight of everyboy who has not given up, because if they do, the difficulty will go down, hence making their business profitable again. This is essentially an inflationary influence (since btcs get easier to obtain with lowering difficulty, hence making miners willing to sell at lower prices).
• They can stop selling, hoping for better times when the prices are more favorable. This is essentially a deflationary influence, since the big stockpile supply of coins held by miners will simply dry out. They'll not sell for months and perhaps years.
• They can sell at prices below their operation cost, in which case they soon cease to be a factor, because they're out of business.

bitcoinionaire psychology

If prices go down and you sit on a big pile of coins, you lose wealth. Nobody likes loosing wealth, I don't like it, you don't like it, the bitcoinionaires don't like it.

In order to become a bitcoinionaire you need to be a hoarder. If you wouldn't hoard, you wouldn't have tens of thousands of bitcoins. A hoarder essentially never likes letting go of his stash. You get rid of as little of your stash as possible to keep your risk and costs in a reasonable balance. Which means, these fat-cats depicted in the picture above, they didn't sell you all they had, not even a fraction. They sold you just about as much as they where personally willing to sacrifice. This means that they're still having the majority of their wealth in the game, and they absolutely do not want to see that devalued to zero.

I've talked to a bunch of these very decent folks, and their sentiment is that they're in for the long haul. True they'll sell "big" positions occasionally, but they keep the majority of their assets stashed away.

If you're expecting the miners/bitcoinionaires to suddenly explode with supply at lowering prices, you're most likely mistaken.

the difficulty/price correlation

For the reasons outlined above, there's a very simple correlation. If prices go down and difficulty goes up, by far and large supply dries out.

However lower prices drive demand (in bitcoin volume) up, because as the price goes down, the buying power (in $/btc) of the would-be buyers increases.

And if the market self-balancing fails, then the difficulty adjust will step in once enough miners have given up.

In sum these dynamics lead to deflation. Since difficulty and hardware turnover moves at a much slower pace then prices, prices are far more likely to adjust to difficulty then the other way around in the long term.

What does all of this mean?

Keep a cool head, and don't let the market fool you. Trust your fundamentals, technicals and sentiment analysis, and tightly control your risk only to what you personally can afford to lose.

If you buy in a mania or sell in a panic (we've see both the past 2 weeks), you're probably going to lose (or diminish your profits).

Study bitcoin and what drives it carefully and come to your own conclusion. Adjust your strategy carefully and maybe, one day a couple years from now, you can be a bitcoinionaire. If not, life is full of other opportunities, so just pick yourself up and try the next.

So chill everyone, and have a good time :)