What Causes Bitcoin’s Price to Go Up and Down?

I see a lot of people whining that Bitcoin and cryptocurrencies are a “worthless bubble,” likely to go to $0. 

This is an idiotic take that I’ll eventually tease relentlessly in a full issue of Finance Daddy. 

As long as there are users willing to use and exchange bitcoin, it will have some value.

However, bitcoin, like any currency or digital platform, is only as valuable as the number of connected people using it. 

So sharp increases and decreases in the number of users should impact the value (I’ll show you this in a moment). 

This is called the “network effect.” The bigger the network, the bigger the value.

It’s actually pretty easy to visualize. Just count the number of “lines” connecting the different users:

As you can see, 2 users can make 1 connection, 5 users can make 10 connections, and 12 users can make 66 connections.

A guy named Robert Metcalfe formalized this value into math and the formula was called Metcalfe’s Law by George Gilder in the early 1990s. (Though there is some debate about what the formula should be.)

In the last few years, a number of articles have been published that show how “bitcoin’s medium- to long-term price follows Metcalfe’s law.”

Let me show you what that means…

Take the market cap of bitcoin — that’s just the price multiplied by the number of bitcoin in existence.

Then take the number of unique bitcoin addresses used and apply Metcalfe’s Law —that’s u*(u-1)/2 (u = unique bitcoin addresses used). We’ll call this number “Bitcoin’s Metcalfe Value.”

Compare those two numbers together over time and this is the chart you see:

Notice how when bitcoin’s “Metcalfe Value” (the orange line) spikes, so too does bitcoin’s market cap (the blue line)? 

And when that number drops, bitcoin’s price tends to follow?

That’s because the correlation between bitcoin’s price and bitcoin’s Metcalfe value is very high: 0.693. 

Meaning, simply, that Bitcoin’s price tends to go up and down depending on the number of unique addresses being used. 

One prediction I have, based on what I’m seeing here, is that I think price swings are going to be bigger in the future (i.e., Bitcoin will be more volatile) relative to the number of new addresses. 

Meaning, it will take fewer new addresses to move the price of Bitcoin. 

Why is that? My suspicion is simple supply and demand. 

As countries, payment processors, companies, and institutions buy up Bitcoin and hold onto it or use it to facilitate transactions, that means there’s a smaller circulating supply left to fulfill an increasing demand for Bitcoin. 

In other words, Bitcoin hoarding distorts prices.

That matters, because it will be harder and harder to detect whether crypto is in a “bubble” or not. But I’ll explain more about that in a future Chart of the Week.

“SHOULD I INVEST IN BITCOIN NOW?”

There’s a compelling investment case for Bitcoin and Ethereum and many other alternative cryptocurrencies. 

But because it is a speculative investment — and there is some risk of a government crackdown — I wouldn’t recommend investing more than 1% to 5% of your total investment portfolio into cryptos.

There’s no easy way to buy Bitcoin in a traditional brokerage account. Eventually we will have our own guide to cryptocurrencies up on diywealth.com…

In the meantime this site will provide some decent (and free) guidance, if you’re interested in getting started.