Bubbles are a common feature of the cryptocurrency market. They happen whenever traders push the price of a crypto beyond its fair value. For meme tokens or altcoins that lack clear fundamentals, almost any rally or price surge could be a bubble. That’s why retail investors need to be careful whenever they buy new coins, since when bubbles burst, it’s often the average trader who suffers the biggest losses.
This article aims to help retail investors navigate market hype. It will discuss the signs of classic crypto bubbles, while also sharing some of the key metrics to consider when trying to spot a bubble. We will share strategies for reducing your exposure to potential crashes, including doing your own fact-based research and building diversified portfolios. By following such strategies, you will be better able to avoid getting hurt when a crypto bubble bursts.
What is a Crypto Bubble?
There are two factors which make a rise in prices a bubble. As stated above, the first is that the price of a cryptocurrency increases beyond what most experts would regard as a fair reflection of its fundamental value. By ‘fundamental value,’ we mean a price which is based solely on the usefulness of the cryptocurrency or its native blockchain. Cryptocurrencies can be useful in different ways, with Bitcoin offering a store of value, for instance, and Ethereum offering a scalable smart-contract platform.
Secondly, crypto bubbles are also characterized by a period of exaggerated hype and excitement. This is what enables prices to rise beyond fair values, with an initial pump then causing many buyers to jump in and bid up a given crypto. Often, a ‘fear of missing out’ takes hold of investors, who become scared of missing an opportunity to make big profits. They can buy a crypto without considering its fundamentals or utility, which adds to the bubble-like aspect of a rally. And eventually, enough traders join a rally that it becomes a crypto bubble.
In other words, unjustified prices and euphoria are the two main features of a crypto bubble. Yet there is a third and no less essential feature, which is that bubbles have to pop. This means that, after a period of excessive price rises, traders begin to take profits. No new buyers come to replace them, so that a coin’s momentum begins to decline dramatically. Current holders can sell only at lower prices, and because there’s a flood of supply, the price can collapse very quickly.
The cryptocurrency market goes through this cycle quite regularly. It’s arguable that most tokens experience only bubbles, since few coins have gained real adoption or delivered a genuinely useful blockchain or platform. As such, investors should be very careful when timing their moves, since they may end up buying just as a bubble is about to end.
Key Reasons Causing a Crypto Bubble
Here are the key causes of crypto bubbles. They’re listed in no particular order.
Social Media Hype
Influencers and other high-profile social media accounts can often stoke up excitement for a cryptocurrency. Even before a particular coin has begun to rally, they may begin talking it up and predicting that it will surge. This can lead to a rush of new buyers, who provide the initial pump that sets a bubble in motion. And once a coin has begun rallying, additional hype from influencers may cause a bubble to expand even further.
Pump Groups
Networks such as Telegram and Discord are now full of groups who coordinate targeted pumps of coins. Because these groups are usually small, they generally target small-cap alts and meme tokens. Such coins usually have very low liquidity, meaning that pump groups can manipulate their prices quite easily. And once they begin a coordinated buy of a chosen coin, genuine traders will enter. The groups will then ‘dump their bags’ on these newcomers, making themselves a profit.
Positive News
Sometimes a coin will enter a bubble because it has enjoyed some genuine adoption or development news. It may have attracted a major investor or partner, or it may have rolled out a new update or product. Yet because the cryptocurrency market remains immature and volatile, a genuine piece of good news can attract an exaggerated response from traders. Often traders will pump a coin in anticipation of a forthcoming update or change, yet then sell in large numbers when this event finally happens.
Identifying a Crypto Bubble
Bubbles are inherent to the cryptocurrency market, so identifying a crypto bubble isn’t actually that hard. Most dramatic price movements are bubbles, in that they usually aren’t based on solid fundamentals and usually end abruptly. However, there are certain signs to watch for, to better help you identify a bubble before it’s too late.
Signs of an Emerging Bubble
Let’s take a look at a clear example of a bubble in the cryptocurrency market. There are many such examples to choose from, yet for the sake of illustration we’ll consider Dogecoin’s rally to an all-time high of $0.7316 on May 8, 2021. As the chart below shows, DOGE climbed very steeply from about $0.058 at the start of April 2021 to this record level, gaining by over 1,000% in only a month.
Source: CoinGecko
Even without looking at the causes of this rally, traders should be aware that a 1,000% gain in a month is almost always a bubble. In traditional finance, no stock rises by this kind of percentage in such a short space of time. Investors should therefore treat such a move with extreme caution, and be prepared to pay for the profits of other traders if they buy too late.
Yet even before DOGE completed its 1,000% rise, there were other signs that it was in a bubble. For one, it benefitted from a massive amount of hype, largely stemming from entrepreneur and famous Dogecoin fan Elon Musk. Musk had been tweeting memes in support of Dogecoin throughout the month leading up to the record high. And on April 24, 2021, Saturday Night Live announced that he would be the host of its broadcast on May 8. Musk commemorated this upcoming episode by tweeting “The Dogefather SNL May 8” on April 28, helping to push DOGE to its ATH.
DOGE proceeded to crash upon reaching its high. Intelligent traders could have guessed this was going to happen, since Dogecoin’s rally had another key feature of a crypto bubble. Namely, it was a meme token without any real adoption or fundamentals. It had witnessed no positive adoption or usage news in the weeks leading up to its ATH. There was nothing justifying its surge in a fundamental sense, so at a certain point the euphoria would die and DOGE would inevitably crash.
Metrics and Indicators to Watch
There are other things to consider when trying to catch a crypto bubble early. While truly reliable metrics are few and far between in crypto, there are a handful which provide some indication that a coin is overvalued.
- Network Value to Transactions (NVT): this is ratio that compares a coin’s market cap with the number of transactions on its blockchain. It provides some insight into whether a coin is overvalued in relation to the amount of activity on its network. A high NVT ratio would suggest that a given coin is priced too highly, in that its high price isn’t justified by a similar high level of network activity.
- Market Value to Realized Value (MVRV): MVRV is the ratio of a crypto’s current price to the average price at which each of its tokens was last traded. As with the NVT ratio, it signals whether a cryptocurrency may be overpriced. If a coin has a high MVRV ratio, this means that its current price is much higher than the average price at which all circulating tokens were last sold. It also suggests that most holders may be sitting on big unrealized profits and may soon sell.
- Active Addresses (24hrs): looking at a coin’s total active addresses in the past 24 hours offers a good gauge as to how much usage it’s attracting. It’s usually a good idea to compare a given altcoin’s active addresses to Bitcoin’s, which still has the most active addresses of any crypto and which is also the biggest in terms of market cap. If a particular meme token or altcoin has a much smaller active address count than Bitcoin, it may be a sign that its rallies aren’t based on solid fundamentals.
Risks Associated with Crypto Bubbles
The main risk associated with bubbles is the risk of losing money, lots of money. Bubbles involve cryptocurrencies rising dramatically in price and then falling dramatically. This puts traders at risk of buying at the top of a cryptocurrency market cycle and then selling at the bottom. If this happens, they may lose most of what they originally invested.
This is the main risk attached to crypto bubbles, but here are a few other dangers.
Scams
Cryptocurrency bubbles usually result in a big increase in trading activity and hype. Fraudsters may try to exploit this by scamming traders, in one of several ways. They may imitate the team of new and trending altcoin, duping investors into sending funds to them. Alternatively, they may approach investors online, via some social network, and offer them an ‘exciting’ investment opportunity related to a rallying coin. Again, this will usually be part of a ruse to send them money.
Losing Funds
Similar to scams, bubbles may cause normally sensible traders to act with haste and without due caution. When this happens, there’s always a risk of sending funds to the wrong address, perhaps by pasting or typing a wallet address incorrectly. For this reason, always take your time and check twice when sending tokens to and from addresses.
Hacks
Because bubbles often involve newer, low-cap tokens that aren’t listed widely, investors may need to trade on decentralized exchanges and DeFi platforms. Such platforms have historically been more at risk of hacks than centralized exchanges. Because of this, traders should make sure to use only the most reputable and secure DEXes, to reduce the chances of losing their funds in an exploit.
Strategies for Navigating Crypto Bubbles
It can be very difficult to safely navigate cryptocurrency market cycles and bubbles. That said, the following are strategies for reducing the risk of loss, and of potentially making bubbles work for you.
Stop-Loss Orders
Traders should use stop-loss orders whenever buying a particularly speculative or risky crypto. The same applies whenever trading over the short term. The reason for this is that stop-loss orders execute a sale of your cryptocurrencies whenever they fall below a set price. Given that bubbles can result in big falls, such orders are all-but indispensable whenever you think you may be dealing with a bubble.
Portfolio Diversification
As the old saying goes, never put all of your eggs in one basket. This old adage applies especially to crypto, with investors advised to put only the smaller parts of their portfolios into the riskiest coins. Not only should they focus mostly on more established and fundamentally sound coins such as Bitcoin, Ethereum and Solana, for instance, but they should spread the remainder of their portfolios widely across a higher number of riskier low-cap tokens. That way, they will reduce their exposure to potential bubbles.
Do Your Own Research
It may be a cliché, but doing your own research is one of the best ways of avoiding big losses. As mentioned above, most bubbles involve tokens with little or no fundamentals. For this reason, researching a coin’s utility, or lack of utility, may give you some idea of whether it may be capable of sustained price rises.
Recognize Hype and Euphoria
Hype and overexcitement is one of the defining features of any crypto bubble. It’s therefore vital to recognize the difference between empty hype and genuine excitement. For example, if a token is gaining attention only on social media, but nowhere else, it may be in a bubble. Look for signs that any hype is justified, be it via significant adoption, partnerships or product launches. If there’s no fundamental basis for or external confirmation of hype, then you may end up getting burned.
Conclusion
Bubbles are a normal part of the cryptocurrency market cycle. They happen whenever a crypto rises much higher – and much more quickly – than its fundamental utility would justify. They’re usually accompanied by lots of hype on social media, and they almost always result in big falls, as first movers dump on newcomers. Yet by doing their own research, managing diversified portfolios and making stop-loss orders, investors can reduce the risks of bubbles hurting them.
Can I Profit from Crypto Bubbles?
Given that bubbles involve early adopters selling to latecomers, it is theoretically possible to profit from excessive rallies. However, traders usually need to be either very lucky or have inside knowledge to be one of the fortunate early movers. If not, they often gamble that a ‘greater fool’ will come along later than them to buy their tokens.
Are Meme Tokens Bubbles?
The vast majority of meme tokens do not have utility or fundamentals. Holders do not use them for practical purposes, which means that there’s no organic source of demand for them. In other words, once people stop believing that their prices will continue rising, they will fall hard.
However, some meme tokens do have fundamentals. Shiba Inu, for example, has been growing and developing its own ecosystem in recent years, including its own layer-two network, Shibarium. This may arguably give it more value, although it doesn’t guarantee long-term price growth.
Are Bubbles the Result of Manipulation?
Many crypto bubbles do follow from deliberate attempts at manipulation. This may come from the pump groups mentioned above, or it may simply come from whales who buy a large amount of a low-cap coin in the expectation that retail traders will follow. On the other hand, bubbles also stem from the nature of cryptocurrency market, which is inherently volatile and immature.
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