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Many of you reading this have likely already read "Are Bitcoins Killing Gold's Price?". If not, you should do so, as it is a worthwhile read.

I am here to give you a word of caution based on my knowledge and personal experience. I became a bitcoin miner back in 2010. I watched my mining profits evaporate, as I failed to sell my bitcoins before the crash. While I still have faith in the currency, (After all, I never thought I'd see the day there was a bitcoin article on SA's front page!) there are a few factors I believe most would-be speculators have little knowledge of.

Hacking is difficult, but not impossible

The currency is gaining popularity and press, but that does not make this currency safe. There really is no fear of counterfeiting of bitcoins, as the algorithm is far too difficult to break, but there is a way to crash the value. The major exchange for bitcoins is Mt. Gox, and they represent roughly 80% of bitcoin trade. Back in 2011, the site was hacked, causing a huge price crash.

There is no reason to simply assume this cannot possibly happen again. Yes, the site has gone through great lengths to increase security. Yes, as the users of bitcoin increase, so too does the resilience of the currency to theft increase. But when more and more money gets offered up as a reward, more and more hackers will attempt to steal some.

That's all speculative though. I think a similar theft through hacking is highly unlikely, though relevant. There's a bigger reason to be careful:

Bitcoin supply will experience a jump soon

Butterfly Labs is releasing its specially designed ASIC (Application-Specific Integrated Circuit) hardware over the next few months. These devices are pieces of hardware which, as the name ASIC implies, are designed for the sole purpose of flooding the market with bitcoins as quickly as possible.

Assuming 100% of miners are using devices comparable to Butterfly Labs' last generation of ASIC modules, the hash rate of miners will increase 8-fold. As some miners will have been using their graphics cards instead, which are significantly slower and are less cost-effective, the increase to the hashrate will likely be higher than 8-fold. The recent popularity of bitcoins will also likely attract more miners, especially of the sort that would purchase these ASIC modules.

The bitcoin algorithm has a defense mechanism built in to prevent hyperinflation. However, the mining algorithm does take some time to react to a spike in the mining capacity of the world, as the difficulty of mining is a logarithmic function. The difficulty increases at a steady pace, whereas the mining capacity of the human race does not.

Thus, the increase in supply will not be negligible. It is possible that this increase in supply may only cause the price to stabilize instead of running upward without restraint, but it could also cause a drop if speculators take it as a cue to take profits.

On the bright side, you do not have to worry about "true" inflation, as the currency has a hard limit of about 21 million bitcoins. This limit cannot be modified by anyone, even the creator of the currency. The currency is in essence decentralized.

The total number of bitcoins in circulation is about 11 million currently. To give an idea of the growth rate, it is projected to take until 2024 to mine another 9 million bitcoins, which results in roughly 10% inflation per year if averaged out.

A safer way to make money on Bitcoins

Become a miner, and be the inflation in bitcoins. It is pretty simple. You order a device from Butterfly Labs for $1,300, plug it in to your computer when it arrives, and start mining away. You can also use your GPU, but this is inadvisable as the profits are negligible. You can watch the coins flow in and rest easy since thousands of your dollars are not subject to the whimsy of the market.

Based on the current value of Bitcoins, and the current difficulty of mining bitcoins, it would take one month of mining for a 60 GH/s bitcoin miner from Butterfly Labs to pay for itself. This assumes the price of bitcoin stays constant, and that you are paying $0.18 per kilowatt of power.

There is a catch, though. The difficulty of mining increases daily, and should the price of bitcoins drop, you will have spent $1,300 on what will not yield any profit for at least a few months. I do still think this course of action is a lot safer than actually purchasing bitcoins, however, as you do not have to sink $10,000 into bitcoins just to see some sort of return from a potential rise in price, but risk losing thousands. Even if the value of bitcoins drop 25%, the ASIC will still pay for itself, it will just take 2-3 months instead of only one.

If you have more money to spend, Butterfly Labs also has a 1,500 Gh/s miner for $29,000. This beast can really crank out the bitcoins, and will still offer the relative safety of being a miner rather than a speculator. Butterfly labs also allows you to trade in your old mining hardware at its purchase value and use the value towards the purchase of new hardware, should your hardware become outdated.

Conclusion

Bitcoins are a fascinating experiment, and I think it has a place in the global economy as we go forward into the future. The idea of an electronic currency is extremely valuable tp people who wish to transfer money internationally. The value of bitcoins will likely continue to rise both short and long-term. Just be careful, as there will be some downward pressures mid-term, though these pressures may not necessarily result in prices of bitcoins decreasing.

If you decide to invest in Bitcoins, I have one last warning. Keep an eye out for competitors in the e-currency market. While this is unlikely to happen anytime soon, if another currency gains legitimacy, it will likely have a negative effect on bitcoins.

Source: Bitcoins: A Word Of Caution

Additional disclosure: I do not own any bitcoins currently, though I may buy some in the future.