Optical. There is no need for any analogue cables anywhere in this setup.
Like I said--only 2 cables needed, TOSlink and USB. That's literally all there is.
Little confused by this statement. Based on WuLFiE's account, seems like he is getting 7.1 via the optical output. I presume the TOSlink is just outputting unprocessed (stereo?) audio since his sound card is not Dolby surround compliant. Am I misinterpreting what you said? Or does the PLYR1 also virtualize surround sound from stereo?
TOSlink/optical is how audio is being sent to the base station, whether that audio 2.0 or 7.1 is another question. WuLFiE must be getting stereo I guess, because I had a Realtek before and I got my sound card specifically so that I could have 7.1 sound.
Here's what my sound card settings can look like:
See? I can set 2, 4, 6, or 8 channels output, and it will send that data over SPDIF Out to the base station. PLYR1 doesn't care whether it's real surround sound or not, it can handle the sound. Of course, if you're sending 2.0 or 2.1 audio to the base station, you're not maximising the use of the PLYR1...
I suppose this also answers your last question: can the PLYR1 virtualise surround from stereo? Yes. Again, this is not what the PLYR1 was really built for (to adapt real surround sound for stereo headphones), but it's possible.
Think of it like this:
When you take a photo with a digital camera--the small, compact ones--you can zoom in up to about 3x right? Beyond that you can use digital zoom. That's not real zoom, because the lens can only physically zoom you in 3x. Digital is the camera's on-board computer trying to guesstimate what it cannot see, and fill in that info into the picture. But it's a digital fill; ultimately it will get something wrong, because the data just isn't there. Virtualising surround from stereo is similar; you can't fill in the missing data with 100% accuracy, because the data is, well, missing.