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What is margin penalty and how does it work?

As per SEBI regulations, margin shortfall penalty is levied on trades performed without sufficient margin ( SPAN & Exposure for F&O and VAR+ELM+Adhoc for equity), net buy premium, physical delivery margins and marked to market losses (if applicable) as prescribed by the exchange.

The penalty levied in case of shortfall in the margin for F&O positions or equity trades:
Short collection for each client
Penalty percentage
(< Rs 1 lakh) And (< 10% of applicable margin)
(= Rs 1 lakh) Or (= 10% of applicable margin)

Note: The penalty is applied as a percentage of the shortfall amount and is posted in your ledger with the narration "Being CFX/F&O/MCX/Equity Margin Penalty Charges for the Trade Date".

Check out this page on the NSE and MCX for more information.

Please read this post for a detailed explanation of what margin penalties are and why they are charged.