Why Investing in Mining is Always a Bet That Prices Will Drop
The one thing that really puzzles people when it comes to evaluating Bitcoin mining profitability is the fact that investing in mining equipment is always a bet that the prices of your chosen currency goes down.
I’ve tried numerous approaches to explaining why this is true, and I’m almost always met with either complete bewilderment (but, it’s free money, how can that not be profitable?) to rage (you simply don’t understanding mining, it’s all about difficulty/price/speed/etc) to weird math-related arguments (well, your calculations cannot be true because you didn’t prove it with my numbers).
As such, I’m going to explain this concept, hopefully in a way that makes it easy to understand.
However, to do so, I’m going to have to trick you.
I want to start with a completely unrelated topic, just to make sure we have something relatively easy to understand. The topic is going to be currency trading with three currencies.
These three currencies are not to be understood as the traditional currencies you usually handle, like US dollars, Euros, or Pounds. To accomplish this, I’m going to call them A, B, and C.
Because we’re going to do some trading with these currencies, we need to establish an initial exchange rate between the currencies. I’m going to start with the following exchange rates:
|Currency Pair||Exchange Rate|
This table should be fairly easy to understand. If you have 1 A, you can trade that for either 2 B or 100 C. If you have one B, you can trade that for either 0.1 A or 50 C. If you have 100 C you can trade that for either 2 B or 1 A.
In fact, let’s start with 2 B and see what we can do. To make this simple, we trade only once per day, using the final exchange rates for that day.
Initial Status: Our holdings initially is 2 B, the equivalent of 1 A or 100 C
First Day of Trading
On the first day of trading, we decide to buy 1 A for our 2 B.
Day 1 Status: Our holding before day 1 is thus 1 A, the equivalent of 2 B or 100 C.
After the first day of trading, the exchange rates have shifted, making C 2.5 times more valuable. Our exchange rates now look like this:
|Currency Pair||Exchange Rate|
Dang! Our value measured in C is now down to 40 C. Even if we still hold 1 A, the exact amount we started with, the increase in C value means our starting sum now translates to a much lower amount of C.
In other words, our value of 1 A means we can get 2.5 times less C today than initially.
Second Day of Trading
Thinking that the C price surge on day one may be a flop, we decide to hold on to our A during day two.
Day 2 Status: Our holding before day 2 thus remains at 1 A, the equivalent of 2 B or 40 C.
After the second day of trading, it turns out we were right! The exchange rate of C drops down to only 10% to its original level, and our exchange rates thus look like this:
|Currency Pair||Exchange Rate|
Luckily, we didn’t buy into the C hype. If we did, we would still hold 40 C, but measured in A, we would suddenly hold only 0.04 A. Measured in B, we would have had only 0.08 B.
In other words, our value of 1 A means we can now get 25 times more C than yesterday.
Final Status: Our holdings after day 2 is thus 1 A, the equivalent of 2 B or 1000 C.
Do we understand each other so far? Everything looks swell? Happy with what’s going on? Good! Because it’s time for me to spring my trap.
I mentioned earlier that I needed to trick you to explain how this all relates to investing in mining and how investing in mining is always a bet that the prices of Bitcoin or your favorite cryptocurrency will drop.
The trick here is that in the scenario above, there aren’t really three currencies. There are just two. One of the currencies, A, is actually a piece of mining equipment, for example a graphics card (GPU).
“Hold on!” you say “That’s not fair! Mining equipment isn’t currency and you can’t trade it like that!”
You’re right! However, you may notice that we didn’t trade A at all, we just bought it at the beginning. In the two days of trading, we used it only to measure how much of the other currencies we held.
Let’s see if my trickery goes further. What if we replaced currency B with US dollars, and currency C with Bitcoin or some other cryptocurrency? Let’s review our positions initially, after day 1 and after day 2.
Note: Remember that during day 1, the price of C, or our cryptocurrency, increased drastically while on day 2, the price of our cryptocurrency dropped like a rock.
Let’s just exchange our statuses with A being GPU, B being USD, and C being Bitcoin.
Initial Status: Our holdings initially is 2 USD, the equivalent of 1 GPU or 100 Bitcoin
Day 1 Status: Our holding before day 1 is thus 1 GPU, the equivalent of 2 USD or 100 Bitcoin.
Day 2 Status: Our holding before day 2 thus remains at 1 GPU the equivalent of 2 USD or 40 Bitcoin.
Final Status: Our holdings after day 2 is thus 1 GPU, the equivalent of 2 USD or 1000 Bitcoin.
See what happens here?
When the price of Bitcoin rises, our value denominated in Bitcoin drops drastically. When the price of Bitcoin crashes, the amount of Bitcoin our holdings represent goes through the roof!
In short, buying mining equipment yields far more reward in Bitcoins when the value of Bitcoins drop than if Bitcoins rise in value.
Your Questions Answered
As always, I’m anticipating, partially because I’ve been trying to explain this to people many times, that you have some questions. Let me get ahead of you and answer some of them right now. If you have other questions, feel free to leave them as comments below.
Q: You Forgot Mining, You Idiot!
Nope, I didn’t forget, I left it out because it would only add to your nightmare.
Go ahead, add mining into the equation. Let’s pick any number, say 10 Bitcoin per day. After day 1, you would have had 50 Bitcoins instead, an increase in Bitcoins of 25%! Amazing, increase, so mining must be profitable, right?
Well, after day two, you’d have 1020 Bitcoins, which represents an increase of Bitcoins of 1020% (yes, that’s one thousand and twenty percent) from our initial value. In other words, a price drop means you get 995% more Bitcoins than if you mine while the price goes up and manage to sell at the top. Clearly, a decreasing price yields far more Bitcoins than mining because a drop in price would add 900 Bitcoins, whereas mining would add 20 Bitcoins.
Q: It’s All About Mining Difficulty, You Idiot!
Not really. If the mining difficulty goes up, you get fewer coins, but even a doubling of the difficulty would only reduce your mining revenue by half. The theory seems to be that increased difficulty leads to a higher price because the cost of mining one coin goes up.
Note: This theory is far from certain, and looking at how major difficulty shifts in other cryptocurrencies have affected prices recently, there doesn’t even seem to be a correlation, much less a dependency between difficulty and price.
In any case, difficulty increase or decrease does not affect profitability anywhere near enough to compensate for the changes in price of a coin.
An increase in difficulty means you get fewer coins, which if the price/difficulty theory holds true means the price will rise. Of course, with fewer coins, that also means less effect of that price increase. Conversely, if the difficulty drops and the price goes down, you have more coins affected by the price decrease.
In the end, it does balance out, but if you think difficulty affects the profitability like that, just run the numbers yourself and see.
Q: You Forgot Equipment Depreciation, You Idiot!
OK, enough with the insults already!
Depreciation means that something loses value over time. For a GPU, you may expect a lifetime of 12 months, so you can on average expect the value of your GPU to depreciate 1/12 per month. The number of months may be different, but the idea is the same.
Let’s go back a couple of steps and look at the investment before my little text replacement trick. In our first example, depreciation would mean that the exchange value of our A would drop by, for example, 1/12 every month.
However, we would still have one A. Our value denominated in other currencies would drop over time, but our ability to mine with our A does not go down.
Our production from having a GPU increases over time when compared to the value of our GPU. For example, after one month, our A or GPU would be worth only 11/12 of the B/USD and C/Bitcoin value, and would give 10 C/Bitcoins. After 11 months, our GPU would be worth only 1/12 of its original value, but would still produce 10 Bitcoins, or whatever value you choose to use.
Q: You’re Using Made-Up Numbers! Use My Numbers, You Idiot!
This is the counter-argument that ultimately demonstrates whether you understand math or are just being argumentative.
Look, replace the numbers with whatever makes you happy. It’s not about whether there is a 1:2 exchange rate or a 1:45, 2:31, or 86:15 exchange rate. It doesn’t matter whether a dollar currently is higher or lower than a Bitcoin.
Try it and see! It’s very easy. Just replace the A:B exchange rate with the price of your favorite mining equipment in USD (don’t forget to convert the value to USD, regardless of whether you buy it using USD or Bitcoins), the B:C ratio with the exchange rate of US dollars to Bitcoins, and A:C with the price of your favorite mining equipment in Bitcoins. Then, do the same experiment, using higher or lower decreases and increases if you like.
Don’t trust me, trust the math.
Oh, and if Bitcoins isn’t your chosen cryptocurrency, just swap Bitcoin in the previous paragraph with Whatevercoin.
Q: Of Course I Want the Price of My Coins to be as High as Possible. Nobody Wants to Sell at a Low Price, You Idiot!
That is true, but tell me, would you rather have 1,000 coins or 100 coins to sell if the price was the same? You’re thinking right but ignore the acquisition of the coins completely.
Remember that when you sell your hardware, you are no longer a miner. You are a coin holder. The argument here is that a mining operation benefits from a falling price, but since your mining operation ceases the moment you sell your mining operation, the falling price no longer benefits you.
In fact, it’s the exact opposite when you just hold coins. You want the price to skyrocket! Until that happens, however, you want to gain as many coins as possible at the lowest price possible, and thus you gain more from a falling price than you do from a rising price.
In our simplified trading example, we stopped the analysis after the price dropped. Add one more day where you trade in your A for 1000 coins after day 2, and see what happens when the price of C or your chosen coin shoots up again on day 3 to the level it was after day 1:
Final Status: Our holdings after day 3 is thus 1020 Bitcoin, the equivalent of 25.5 GPUs or 510 US dollars.
If you were just mining at the rate of the 10 Bitcoins per day from the example in the first question, the results would be:
Final Status: Our holdings after day 3 is thus 1 GPU and 30 Bitcoin, the equivalent of 1.8 GPUs or 36 US dollars.
Mining yields a profit of 34 dollars while mining plus selling your hardware yields 508 dollars.
I doubt it, because this is a topic that seems to bring rage to miners all over cryptocurrency land. However, the short version of this article is this:
Mining is always most profitable when the price of Bitcoin goes down. If you invest in mining equipment your highest profit comes when the price of Bitcoin crashes.
That doesn’t mean that mining isn’t profitable when the price rises, only that you’re missing out on a lot of coins when that happens.
Still disagree? Leave your comment below and I’ll try to answer any question you have. Perhaps you know better? Heck, I might even update this article to include your question, and you’ll be famous for setting me straight!