Fiddler is a proxy; it only sees traffic that is sent to it. If you configure IE to point its proxy settings to some other proxy (your Proxy Configuration Script, what you're calling the "second option"), then the traffic is sent to that proxy, not Fiddler.
To make Fiddler work, configure your proxy Configuration Script. Then start Fiddler, which will reset your proxy settings to point to itself.
If something else comes along and changes the proxy settings out from under Fiddler, you will need to disable that "Something else" to stop it from doing that.
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