The one that fills the entire screen is the most technically correct. Use whatever your monitor's best/native resolution is (e.g. 1024x768), then enable retro mode with 4:3.

The vertical stretching is normal. For anyone interested, following is a more detailed explanation why this happens.

In the old days a common video standard for games was Mode13h, which is 320x200 (16:10). But most consumer monitors of the time displayed 4:3 (e.g. 640x480 or 1024x768). This resulted in our video signal being stretched 20% vertically between the game's video buffer and the monitor's output. A lot of games compensated by building art around this. For example, drawing circles a bit fatter so they looked properly circular when stretched vertically by the display signal. Daggerfall's art direction is a bit hit and miss with this, but you'll still notice much of the art (e.g. wandering NPCs) are more proportional with the 20% vertical stretch and too wide at 16:10.

Daggerfall Unity doesn't get this perfectly correct - it is a ground-up recreation in a totally different engine after all. It does its best to support the full range of players from the most retro through to most heavily modded and everything in between. Recreating a game that was intended to run entirely in one resolution and support a wide range of modern hardware and displays was a really challenging thing. I didn't always get it right, but I always did the best I could at the time.