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2 missed an “insert” markup; in conclusion the benefits are…
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It's option 1. The feat's wording mirrors the Damage Your Opponent wording, to the point of being a direct edit of it:

While When grappling, you can deal damage to your opponent equivalent to make an unarmed strike. Make an opposed grapple check in place of an attack. If you win, you to deal nonlethal normal damage as normal for your unarmed strike (1d3 points for Medium attackers or 1d2 points for Small attackers, plus Strength modifiers) with a successful grapple check. If you want to deal lethal damage, you take a You do not suffer the usualYou do not suffer the usual −4 penalty on your grapple checkfor dealing normal damage for dealing normal damage.

There would be even fewer strike-throughs, but they moved around a couple of clauses (making dependent clauses follow instead of precede, which is admittedly cleaner writing), and made the odd choice to call it “normal” damage instead of the normal “lethal” damage.

There much less to rest an argument for any other option on. It can't be the second option, because the feat is not worded as a single-point trigger — “when grappling” is not the same as “when you grapple”!

It can't be the third option — as you note it's the least likely — because given a straightforward alternative (option 1) that requires fewer assumptions and fewer additions of unmentioned procedural steps, basic logical principles require rejecting such a reading unless firm support can be found that makes it the overwhelmingly more likely reading.

So in conclusion, the real benefit is threefold: you do generally better damage, it's lethal instead of non-lethal, and it's an effective +4 to hit with it.

It's option 1. The feat's wording mirrors the Damage Your Opponent wording, to the point of being a direct edit of it:

While When grappling, you can deal damage to your opponent equivalent to make an unarmed strike. Make an opposed grapple check in place of an attack. If you win, you to deal nonlethal normal damage as normal for your unarmed strike (1d3 points for Medium attackers or 1d2 points for Small attackers, plus Strength modifiers) with a successful grapple check. If you want to deal lethal damage, you take a You do not suffer the usual −4 penalty on your grapple checkfor dealing normal damage.

There would be even fewer strike-throughs, but they moved around a couple of clauses (making dependent clauses follow instead of precede, which is admittedly cleaner writing), and made the odd choice to call it “normal” damage instead of the normal “lethal” damage.

There much less to rest an argument for any other option on. It can't be the second option, because the feat is not worded as a single-point trigger — “when grappling” is not the same as “when you grapple”!

It can't be the third option — as you note it's the least likely — because given a straightforward alternative (option 1) that requires fewer assumptions and fewer additions of unmentioned procedural steps, basic logical principles require rejecting such a reading unless firm support can be found that makes it the overwhelmingly more likely reading.

It's option 1. The feat's wording mirrors the Damage Your Opponent wording, to the point of being a direct edit of it:

While When grappling, you can deal damage to your opponent equivalent to make an unarmed strike. Make an opposed grapple check in place of an attack. If you win, you to deal nonlethal normal damage as normal for your unarmed strike (1d3 points for Medium attackers or 1d2 points for Small attackers, plus Strength modifiers) with a successful grapple check. If you want to deal lethal damage, you take a You do not suffer the usual −4 penalty on your grapple check for dealing normal damage.

There would be even fewer strike-throughs, but they moved around a couple of clauses (making dependent clauses follow instead of precede, which is admittedly cleaner writing), and made the odd choice to call it “normal” damage instead of the normal “lethal” damage.

There much less to rest an argument for any other option on. It can't be the second option, because the feat is not worded as a single-point trigger — “when grappling” is not the same as “when you grapple”!

It can't be the third option — as you note it's the least likely — because given a straightforward alternative (option 1) that requires fewer assumptions and fewer additions of unmentioned procedural steps, basic logical principles require rejecting such a reading unless firm support can be found that makes it the overwhelmingly more likely reading.

So in conclusion, the real benefit is threefold: you do generally better damage, it's lethal instead of non-lethal, and it's an effective +4 to hit with it.

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It's option 1. The feat's wording mirrors the Damage Your Opponent wording, to the point of being a direct edit of it:

While When grappling, you can deal damage to your opponent equivalent to make an unarmed strike. Make an opposed grapple check in place of an attack. If you win, you to deal nonlethal normal damage as normal for your unarmed strike (1d3 points for Medium attackers or 1d2 points for Small attackers, plus Strength modifiers) with a successful grapple check. If you want to deal lethal damage, you take a You do not suffer the usual −4 penalty on your grapple checkfor dealing normal damage.

There would be even fewer strike-throughs, but they moved around a couple of clauses (making dependent clauses follow instead of precede, which is admittedly cleaner writing), and made the odd choice to call it “normal” damage instead of the normal “lethal” damage.

There much less to rest an argument for any other option on. It can't be the second option, because the feat is not worded as a single-point trigger — “when grappling” is not the same as “when you grapple”!

It can't be the third option — as you note it's the least likely — because given a straightforward alternative (option 1) that requires fewer assumptions and fewer additions of unmentioned procedural steps, basic logical principles require rejecting such a reading unless firm support can be found that makes it the overwhelmingly more likely reading.