From blow-up to burst: Understanding crypto bubbles

Cryptocurrency traders are no strangers to emotional extremes, with optimism driving prices to unexpected heights – until the “fear of missing out” (FOMO) turns into “fear, uncertainty, and doubt” (FUD). These unpredictable reversals are so common they’ve earned a name: “crypto bubbles.”

In this guide, we’ll explain crypto bubbles, the specifics regarding what causes them to form, what to do if you find yourself caught in one, and a few real-life examples. We’ll also explore ways to identify and avoid them before they burst. 

What is a crypto bubble?

The term “crypto bubble” refers to a rapid, unsustainable surge in the price of digital assets, driven largely by speculation rather than strong fundamentals. The “bubble” underscores the fragile nature of price increases that are often fueled by media hype and emotional decision-making. 

During these periods, traders may chase trends without fully evaluating the cryptocurrency’s underlying value, creating temporary overvaluations. When the hype fades, or negative news happens, these inflated prices can collapse just as quickly as they rose.

How does a crypto bubble form? 

Crypto bubbles often arise from a mix of greed, hype, and unrealistic expectations. Traders buy cryptocurrencies at inflated prices, assuming the momentum will continue indefinitely – until the crypto bubble bursts. 

• Inexperienced investors: Drawn by promises of fast profits, crypto bubbles attract retail traders with little understanding of the market. These newcomers often rely on flashy headlines and social media hype rather than researching fundamentals or blockchain technology. This influx of naïve capital can create a self-reinforcing cycle of rising prices. 
• Media frenzy: Positive coverage from influencers, celebrities, or news outlets amplifies speculative excitement. As cryptocurrencies dominate conversations, buyers feel the FOMO and rush to invest in trending assets.
• Technological hype: Cryptocurrencies are often marketed as revolutionary technologies, with terms like “blockchain,” “decentralized finance” (DeFi), and “nonfungible tokens” (NFTs) fueling investor optimism. Even unproven projects may see dramatic price surges due to their perceived innovation.
• Misunderstanding valuations: During bubbles, traders may mistake skyrocketing prices for intrinsic value. Instead of evaluating metrics like tokenomics, inflation rates, or burning mechanisms, investors base predictions on hype rather than a cryptocurrency’s design and limitations.  

Warning signs of a crypto bubble crash

Crypto bubbles thrive on irrational exuberance, where market sentiment overshadows reason. While getting caught up in the hype can be easy, traders who maintain a level head can spot the warning signs of a bubble nearing its breaking point. Those include: 

• Extreme public interest: A sharp rise in trading activity alongside soaring cryptocurrency prices often signals a bubble. Check volume charts to compare daily trades with historical averages and use tools like Google Trends to see if searches for terms like “Bitcoin” or “cryptocurrency” are spiking to all-time highs. 
• Unrealistic price predictions: Overly optimistic targets from crypto influencers or analysts, especially without referencing fundamentals like tokenomics, often indicate bubble-driven euphoria. While bullish predictions aren’t inherently bad, wild, unsupported forecasts are a key red flag.
• Relative strength index (RSI) scores: The RSI tracks momentum and speed in trading activity. If RSI scores hover above 70 (overbought territory) for an extended period, it could point to unsustainable price growth typical of bubble conditions.
• Crypto Fear and Greed Index: This index from CoinMarketCap combines metrics like price volatility, social media trends, and surveys to gauge market sentiment on a scale of zero to 100. During bubble phases, the index often sits in “extreme greed” territory (near 100) for prolonged periods.
• Increased leverage: Overconfidence can drive traders to take on excessive risk by borrowing funds to open long-leveraged positions. This influx of leverage inflates prices further, exacerbating volatility and increasing the risk of a sharp correction.

Examples of crypto bubbles that burst 

Throughout cryptocurrency’s history, many projects that appeared too good to be true have turned out to be worse than expected, whether caused by hacks, scams, or poorly designed protocols. Here are two of the most notable examples:

ICO bubble of 2018

Following Bitcoin’s surge to $20,000 per coin, many investors turned their attention to initial coin offerings (ICOs), a speculative class of early-stage crypto projects. Promising exclusive access to cutting-edge protocols, many ICOs offered enticing perks like high staking rewards or yield farming opportunities.

Unfortunately, this digital gold rush attracted scammers who launched fraudulent ICOs, taking advantage of the decentralized and relatively unregulated crypto space. These “pump and dump” schemes tricked investors into funding fake projects before the creators disappeared with their money. 

As scam activity increased, the market cap for ICOs fell dramatically – from nearly $830 billion in 2018 to $100 billion by the end of 2019. Some estimates suggest that over 80% of ICOs during this period were scams, with investors losing roughly $9 million daily at the peak of the bubble. 

NFT bubble of 2021–2022

NFTs became one of crypto’s hottest markets in 2021, thanks to endorsements from celebrities like Snoop Dogg, Paris Hilton, and Jimmy Kimmel. Collections like CryptoPunks, Bored Ape Yacht Club (BAYC), and Doodles saw unprecedented demand, with some NFTs selling for millions, including a $69 million NFT that captured global attention.

But as the broader crypto market weakened, NFTs enthusiasm faded. Trading volumes on platforms like OpenSea, which hit $6 billion in January 2022, dropped to $1 billion by June 2022. The speculative hype driving the NFT market proved unsustainable, leaving many investors with devalued assets.

Terra Luna bubble of 2022

Terraform Labs’ Terra blockchain gained immense popularity from 2020 to 2021, mainly due to its innovative algorithmic stablecoin, TerraUSD (UST). Unlike reserve-backed stablecoins such as USD Coin (USDT) or Tether (USDT), UST relied on a complex incentive mechanism rather than holding equivalent assets in reserve. In simple terms, traders maintained UST’s 1:1 peg with the U.S. dollar by countertrading with Terra’s cryptocurrency, LUNA. Depending on market conditions, the Terra protocol either created (“minted) or destroyed (“burned”) these tokens to stabilize UST’s value. At its peak, about 72% of UST holders deposited their funds into the blockchain’s Anchor protocol, lured by interest rates approaching 20% APY.

The bubble burst in 2022 after a series of targeted, high-volume swaps on the decentralized exchange (DEX) Curve caused UST to lose its peg. This destabilization led to widespread panic in the market. Despite Terraform Labs’ efforts to restore confidence, there wasn’t enough capital to counter the immense sell pressure on UST and LUNA. Within weeks, the Terra ecosystem collapsed, erasing an estimated $50 billion from the crypto market.

Is Bitcoin a bubble?

As the first and largest cryptocurrency, Bitcoin (BTC) often faces scrutiny from crypto skeptics who label it a bubble. While Bitcoin has experienced dramatic price swings throughout its history, its market cap has steadily grown as adoption increases, even during periods of volatility.

Bitcoin’s relatively small market size compared to established assets like stocks or gold makes it more susceptible to “bubble phases,” but these periods of overvaluation have historically corrected before resuming long-term growth. Bitcoin also continues to gain legitimacy through integrations with financial systems, adoption by prominent investors, and inclusion in financial instruments like exchange-traded funds (ETFs). 

While predicting Bitcoin’s future price with certainty is impossible, its overall trajectory doesn’t align with the characteristics of a bubble. Zooming out on Bitcoin’s long-term chart reveals an upward trend rather than an asset headed toward zero. 

How to handle a crypto bubble

Even with careful planning, crypto traders can sometimes find themselves caught in an unexpected bubble. Fortunately, there are ways to minimize damage and safeguard investments during a market drawdown. 

• Develop a clear investment strategy: Avoid FOMO by creating a well-planned trading plan before entering the market. Research a cryptocurrency’s tokenomics, use case, and historical performance to evaluate whether it aligns with your financial goals. A strong investment thesis helps block out market noise and fosters better decision-making.  
• Set stop-loss orders: Stop-loss and stop-limit orders automatically sell your crypto holdings once they hit a predetermined price. These tools can help protect your portfolio by preserving capital and mitigating the impact of steep declines at the end of a bubble.  
• Use take-profit orders: Secure gains by placing take-profit orders, which sell your crypto when it reaches a target price. This strategy can help traders exit positions during periods of excessive market greed, potentially avoiding the fallout of a bursting bubble.
• Rely on reputable analysis: Stay informed through credible crypto news outlets, onchain analytics, and trusted research rather than social media hype or influencers. Tools like the Relative Strength Index (RSI) and other technical indicators can provide clearer signals about whether the market is overheating.

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No one wants to get caught in a crypto bubble. The same goes for dealing with unnecessary stress during tax season. CoinTracker simplifies crypto tax reporting by keeping detailed records of all your transactions, helping you identify potential deductions and tax-loss harvesting opportunities.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.