What It Means
When a seller fails to actually deliver shares they owe on settlement day — a short delivery — the exchange steps in and buys the missing shares from the open market on the seller's behalf, in a special auction session, so the buyer still gets their shares. The defaulting seller pays whatever the auction costs, plus a penalty — the auction penalty.
How It Works
The auction price is allowed to move up to ±20% from the previous settlement price, so a defaulting seller can end up paying meaningfully more than the original trade price just to source the shares. If the exchange can't procure the shares even through the auction, the trade is closed out financially instead, at a close-out rate, rather than through actual delivery.
Warning
This is the real financial risk sitting behind BTST trades and Trade to Trade (T2T) segment stocks — both situations where a delivery hiccup upstream can turn into an auction penalty for you, even though you did nothing wrong yourself.