Cryptocurrencies offer investors a new frontier for investing, yet due to lack of reliable measurements for value there can be rapid price increases and consequently bubble formation.
Understanding crypto bubbles can assist both experienced investors and newcomers to the market in making risky decisions and can assist with market analyses and regulatory implementation aimed at stabilizing crypto markets.
Identifying a crypto bubble
Cryptocurrencies have quickly gained in popularity over time and even though their adoption rates are low within real economies, some individuals hold out hope that cryptocurrencies will provide significant returns in future. Yet most people invest in them solely as speculation, often leading to price bubbles.
There are numerous indicators available to detect crypto bubbles, but these indicators can be difficult to apply in an ever-evolving market such as cryptocurrency. These indicators include studying investor triggers and popularity among certain coins as well as social media analysis.
Bubbles occur when an asset’s price exceeds its intrinsic value, and can be observed both on stock markets and crypto markets, leading to losses for investors and traders.
The boom phase
If a price increases rapidly for no technical or other fundamental reason, this could be considered an asset bubble. Recent crypto price crashes (and general stagnation of growth) may be an indicator that this particular bubble is starting to burst.
During a boom phase, an asset’s prices rapidly surge and draw media coverage. New traders enter out of fear that they’ll miss an “once-in-a-lifetime opportunity”, further pushing its price skyward.
At some point, when the speculation bubble has reached its limit and central banks start tightening monetary policy to curb inflation and reduce debt levels, new investors will stop coming in, prices will decline and traders who bought during the boom phase will suffer losses; eventually the bubble bursts.
The euphoria phase
At this point, investors often lose all sense of caution as they become caught up in the excitement surrounding an investment opportunity. When this occurs, the “greater fool theory” often kicks in; sometimes leading to dramatic value surges as soon as an influencer tweet or event announcement occur.
Many euphoric periods are driven by investor greed and their desire for quick profits, leading prices to skyrocket even without having any true intrinsic value.
Euphoria can also be caused by new and exciting technology being released to the market. For example, during the dotcom bubble of late 1990s tech stocks saw rapid expansion with Nasdaq index quintupling from 1995-2000.
The displacement phase
At this stage, investors begin flocking to the cryptocurrency market, leading to further price gains. This stage can be defined by fear of missing out (FOMO), with companies marketing their coins by adding “blockchain” to their names or seeking celebrity endorsement.
Momentum gained in this phase can quickly propel an asset’s price past unimaginable heights, prompting traders to ignore caution in favor of hype and FOMO.
Once the euphoria phase passes, asset bubbles tend to start subsiding once profit-taking begins and warnings about them arise. Asset bubbles don’t last forever but there are steps you can take to avoid being caught up in one: remembering that price doesn’t always equal value is of great help in protecting yourself against becoming part of one.
The panic phase
The panic phase occurs when investors realize that their bubble has burst, leading to massive amounts of sell pressure as assets lose value quickly. At this stage, those fooled by an artificially high price and who didn’t conduct research will realize they made a costly error in investing.
Experienced investors begin to recognize that prices have reached unsustainable heights and look for smaller investments with greater potential. At this stage, seasoned investors begin realizing that cryptocurrencies, unlike traditional assets, do not possess intrinsic value – yet this doesn’t mean cryptos won’t remain around; actually the crash can help boost popularity and value once more if done properly; this allows smart traders to ride out this wave and emerge victorious from it.
