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It's option 1.
Conversion and Damage Based On only occur in the following order:
Physical -> Lightning -> Cold -> Fire -> Chaos
This is to prevent looping.
The relevant case here: If a monster deals x% of Fire Damage as extra Fire Damage, then his Fire Damage is now higher and thus the relative bonus increases, further increasing his Fire Damage, etc. etc.
Another example: x% of Cold Damage as Physical, combined with Hatred. Hatred increases Cold Damage -> increases Physical Damage -> increases yield from Hatred...
Vipermagi is correct as usual.