The rise of the Bitcoin has prompted unprecedented attention for the digital currency around the world. As exchange rates for Bitcoin have soared from below $10 as recently as last summer to well over $100 recently, entrepreneurs are looking for ways to cash in on the craze. With nascent plans in the works for a network of Bitcoin ATMs stretching from California to Cyprus, many are seeing the billion-dollar market for the cybercurrency as just the tip of the iceberg for what could become a much larger market. Some have even speculated that the declines in precious-metals investments SPDR Gold (GLD 0.01%), iShares Silver (SLV -0.52%), and Central Fund of Canada (CEF -0.22%) are due in part to Bitcoin's taking over their traditional role as safe-haven assets in light of banking-system uncertainty in Europe.
But before you jump into the Bitcoin market yourself, you need to understand just how volatile that market is. Even though Bitcoin hasn't been around all that long, its history is still long enough to have included a cycle of speculative frenzy followed by a bursting bubble that created big losses for those who bought into the hype.
Turning the clock back
Back in 2011, Bitcoin had a similar upsurge in popularity in response to a massive price move. In the span of a single year, prices for the digital currency rose from $0.003 to $10, a 300,000% increase that evoked massive interest from performance-following investors. As proponents pointed to the virtues of Bitcoin in comparison to the central-bank-influenced traditional currency markets, rising prices seemed to validate the Bitcoin model. Eventually, Bitcoin prices reached $30.
But in the span of just a few short months, Bitcoin lost 90% of those gains, plunging back to the $2 to $3 level. As Fool contributor Mike Pienciak noted at the time, even lead Bitcoin developer Gavin Andresen cautioned would-be investors about the cybercurrency's volatility:
Bitcoin will get mentioned someplace with lots of readers, a bunch of those readers will like the idea and try to buy Bitcoins, their price will rise which will draw even more people to "invest," which will drive the price up even more ... until people decide that the price isn't going to rise any more and everybody rushes to sell before the price drops. I predict there will be between one and five Bitcoin bubbles (price will double or more and then crash back down below the starting price) in the next four years.
At this point, Andresen's prediction has only come half-true. But as previous bubbles in other assets have shown, an influx of desperate buyers can only go so far before demand evaporates, causing prices to crash.
Will Bitcoin succeed or fail?
Proponents of Bitcoin will rightly point out that over time, the prevailing trend of the cybercurrency's price has been upward. Even looking back to before the latest speculative fever took over, Bitcoin's price in the $10 to $15 range marked a major recovery from its 2011 losses. Even if prices crash, they may not erase all of Bitcoin's long-term gains.
Bitcoin's long-term success, however, will have little comfort for those who've paid $100 to $150 or more for Bitcoin in recent days. Bank of America (BAC -0.77%), Wells Fargo (WFC 1.72%), and numerous other big U.S. banks may have raised the ire of millions of Americans during the financial crisis for their mortgage-lending excesses and may not pay much interest to their depositors, but what they do offer is a federally insured vehicle to protect your savings. Before you abandon traditional bank accounts to become a Bitcoin buyer, be sure you understand just how much people just like you suffered during the last Bitcoin bubble.