The Gap Between Difficulty and Price, The Case for Mining vs. Trading.

If you look at Bitcoin value verses the US Dollar, it is clear that we are approaching the bottoming of prices from the Bitcoin bubble. This can be seen in graphic form from a graph I generated by clicking some buttons at bitcoincharts.com.

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Based on this graph, prices peaked around June 10th at 30 USD per BTC. The bubble that started at the beginning of May 2011 is finally nearing the end of the value destruction that it has caused. 1 Bitcoin is probably really worth around the 3.50 USD range so it can still drop further. Based on the trend data I have presented, I feel that anything lower is under valued. But if you think about it in the grand scheme of things, what global currencies are consistently worth more than the US dollar? If we disregard the metals/commodities like gold and silver, two come to mind. The British Pound (GBP) and the Euro (EUR). At current market rates, 1.58 USD buys you 1 GBP and 1.38 USD buys you a EUR. Compared to that, 5.24 USD per 1 BTC is still a pretty heavy value difference and does seem a bit unreasonable considering how much smaller the Bitcoin marketplace is compared to say, the entire European market.

However Bitcoin does not act like a typical currency since it knows no borders. One needs to also look at mining trends for a clearer picture. Which when you do, we see a totally different picture. Heres a chart of the same timeframe from a mining difficulty and network hashrate perspective. (chart pulled from http://bitcoin.sipa.be/)

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Based on this graph, Mining peaked some time in mid July and has only started to drop in very small amounts. While the timing of each difficulty change is very easy to predict, (once every two weeks) the actual difficulty rate can be a bit tougher to call. In June, its safe to say that everyone interested in Bitcoin mining had invested in some mining hardware in hopes of striking it rich. I remember reading some calculations of people claiming that they could pay off an entire mining rig within 30 days. But since a very large population had the same idea, we got a parabolic rise in difficulty starting in May. Specifically June 6th to June 15th had a difficulty change from 567,270 to 876,954. A difficulty spike of nearly 55%. Because the difficulty rate had caught up to the large rise in network power, mining profit had reached equilibrium with the price of hardware. I calculated this by considering that you get 50 BTC per block mined. Since 50 BTC was worth around 850 USD for most of June, if you found just 1 block, your average mining rig could be paid for.

From this point forward, those who wanted to continue to get into the Bitcoin mining industry had to invest at a loss since serious multi-GPU computers that can temporarily beat the difficulty could end up costing over 1000 USD. However once you factor in the decline in the overall price of Bitcoin, it is safe to say that its the electricity rates that are now reaching equilibrium with any Bitcoin mining operation. For example, lets say the rate that which you buy electricity for is 15 cents per kilowatt hour. Lets also say that your mining rig uses 400 watts under load and you run it 24/7. You would need to mine at least 0.27 BTC per 24h to break even, assuming the 5.24 USD per 1 BTC rate holds. At the current difficulty rate of 1,777,774, that's 470 megahashes per second, which most video cards can not achieve. The few video cards that can, might end up drawing more than 400 watts of power once you calculate the rest of the components and power supply inefficiencies.

Things get even more ugly if you match up the difficulty rates to the price of Bitcoin. Lets look at a few dates. 2011-08-01 had a difficulty rate of  1,888,786.71 which was the peak in difficulty. Prices that day were around 14 USD per 1 BTC. Using our previous example of 470 MHash/s, you could make 0.25 BTC or 3.50 USD per day provided you were part of a stable mining pool. Since the current difficulty is 1,777,774, you could potentially make 0.27 BTC per day. Not bad until we do the dollar conversion. 0.27 BTC today equates to roughly 1.39 USD. I am fairly certain there hasn't been a massive wave of hyperinflation in the US since August, a dollar today is worth the same as it was last month. Therefore we can conclude that while difficulty is down 5.8% since August 1st, and this results in a 8% increase in overall Bitcoin mining with our example hashrate of 470 MHash/s, The total dollar value of Bitcoin you could mine has dropped over 60%. Ouch!

Combine these obstacles, and one can easily declare that the first Bitcoin mining gold rush/arms race has ended and the current overall network hash rate is unsustainable. I expect a continuing correction as more miners get forced out of the market due to growing expenses. I expect those that remain will be people who are all-in and its too late for them to back out just yet. The others that stay will be the hobbyists that don't care what the price is as long as their gaming rigs are doing something while otherwise idling to torrent downloads. Ones that get free hardware or free electricity will also remain for the time being. As for growth? I don't think its likely until next year when we start seeing more efficient hardware for Bitcoin mining or until the price increases above the 7 USD per 1 BTC exchange rate again. The next difficulty rate is set to arrive in 2 days and I am anticipating a 2% drop in difficulty. Since difficulty peaked in July, but price peaked in June, the effect difficulty rates have on prices is a laggy indicator at best. The fact that its designed to change every two weeks is lag in itself and I feel that this is a feature and not a bug. If the difficulty were constantly floating to the networks hashrate, it would be pretty harsh. This would make it harder to mine with the increased instability since you couldn't forecast to a set time frame. Compound that with overall price instability, and you would have a disaster. I speculate that while its definitely not a good time to get into mining, trading can prove to be lucrative if done in small doses at the right time. Plan accordingly.