In recent weeks, something interesting has happened to the price of bitcoins: It hasn't changed very much. In December, Bitcoin prices gyrated wildly, but since the start of the year it's gradually gotten less volatile.
Bitcoin's declining volatility is part of a recurring cycle the Bitcoin economy has experienced repeatedly over the past three years. It starts when a wave of publicity attracts new Bitcoin speculators and pushes Bitcoin prices to unprecedented highs. That creates an unsustainable price bubble. The bubble pops, leading to plummeting prices and high volatility. But then the price gradually stabilizes, settling on a "new normal" price.
This pattern suggests that the extreme price volatility that has bedeviled Bitcoin since its inception is likely to prove a temporary phenomenon. Bitcoin prices become volatile when a wave of media attention attracts a swarm of new users. As the Bitcoin economy grows and matures, these growing pains will become less frequent and less severe.
Four bubbles
Mainstream media coverage of Bitcoin began in April 2011, at a time when one Bitcoin went for around $0.75. The chart above shows that by June 2011, Bitcoin's price had risen 40-fold to more than $30. Then it crashed, falling below $2 in November before stabilizing at around $5 in early 2012.
Notice that after the initial boom and bust, Bitcoin's price gradually got more stable. In January and February of 2012, Bitcoin's price ranged from $3.87 to $7.22— a significant range but not the wild fluctuations of the previous year. In March, April, and May, the price stayed between $4.30 and $5.48.
In the second half of 2012, the pattern repeated itself, albeit on a smaller scale. In June, Bitcoin prices began to rise rapidly, reaching a high of $15.40 on Aug. 13. Then the currency promptly crashed, falling to a low of $7.58 before stabilizing around $13.50 in December 2012.
The pattern repeated itself yet again in the first three quarters of 2013. From $13.50 at the start of the year, Bitcoin's value soared to $266, then crashed to $50 later that same month. As summer turned to fall, the price of one Bitcoin had stabilized around $130.
Finally, here's a chart of Bitcoin prices over the last four months. The price rose from $130 to $1,242, then crashed to $455 before stabilizing around $900.
The cycle
Each of these four periods involves the same basic pattern:
1. Bitcoin gets a wave of positive press. This attracts new Bitcoin users who begin buying Bitcoins. The process becomes self-perpetuating: new users generate higher prices, which generates more press coverage, which attracts new users.
2. The bubble pops, usually triggered by some kind of bad news. Many of the Bitcoin newbies who had flooded into the market in the preceding weeks panic. That kicks off a feedback loop of its own: falling prices generate more panic selling, which pushes the price down even more.
3. Eventually, everyone who is inclined to panic-sell has done so, and the price bottoms out. Over the following weeks or months, there are a series of "aftershocks" as each price rise triggers a new wave of profit-taking. But each rise and fall is smaller than the one that preceded it.
4. Bitcoin's price stabilizes. Most of the bitcoins are in the hands of people who intend to hold them for the long term. With no price fluctuations to report on, press attention to the currency drops off. Bitcoins prices are relatively stable until the next boom begins.
Notice that each turn of the cycle has left Bitcoin's price significantly higher than it was before. From an early 2011 price of $0.75, the price stabilized at $5 in early 2012, at $13.50 in early 2013, at $130 in late 2013, and at $900 today.
Notice also that periods of price stability have never led to sudden price drops. So far, major price drops have only come on the heels of even larger price increases. Each crash has bottomed out above the price Bitcoin was at at the start of the preceding boom. The crash in mid-2013, for example, reached a low of $50, way above the price of $13.50 at the beginning of 2013.
The obvious explanation for this pattern is that each new wave of publicity has expanded the Bitcoin economy. In each boom, some new Bitcoin users speculate for a few weeks and then cash out, creating volatility. But a significant number of the newcomers in each wave stick around, permanently expanding demand for Bitcoins.
Of course, these cycles can't continue forever. The process depends on new people being drawn into the Bitcoin economy. If Bitcoin keeps growing, it won't be long before the currency is so widely known and used that there's little room for further growth.
Once that point is reached, we should expect Bitcoin's price to behave the way it does in stage 4 of the cycle, when waves of publicity aren't drawing new people into the Bitcoin economy. These are periods of price stability, like May 2012, September 2013 and right now, when the price doesn't change very much from day to day.
Of course, it's important to acknowledge that past performance is no guarantee of future results. The fact that Bitcoin's price has never collapsed after a period of price stability, and that price declines have never wiped out the gains from a preceding boom, doesn't mean these things could never happen.
Still, the longer the Bitcoin economy grows, the greater confidence users will have in its continued stability. And that has important implications for Bitcoin users. One is that volatility doesn't strike at random. If you're thinking about doing business in Bitcoins and you want to predict whether Bitcoin's price is likely to fall tomorrow, you just need to look at what happened in the past couple of weeks. If prices were stable in the recent past, they'll probably be stable in the near future too.
Second, when thinking about Bitcoin's long-term future, it's misleading to think about the average level of volatility in the past. That volatility mostly reflects the currency's rapid growth, not something inherent in the technology. It's mathematically impossible for Bitcoin's rapid growth to continue forever. Once it slows, there's good reason to think volatility will decline with it.
