When you're tightening a nut that uses a cotter pin, do you only tighten enough so the pin can slide in or can you tighten further as well?
I drew a picture to illustrate what I'm asking. Is the castle nut only supposed to be tightened like #2? So cotter pin touches or is #1 acceptable too? 
Torque to specifications then further tighten to align nearest slot in nut to hole, never back nut off to align hole.
Well, if its a car suspension, im sure there is a toque spec. But in general tighten so cutter pin will be in the middle. But if its something like a wheel bearing you have to make sure the wheel can spin and not bind up due to over tightening.
As already mentioned above it is best to use a torque wrench because overtightening a fastener can cause to stretch when it gets hot and break.The only way to be sure is to use the recommended torque found in the repair-manual for the specific model.
As per the other answer, you have to meet the torque spec, but also for bearings you may have to check the free play ie so many thousandths (mm or inches) measured with a dial gauge at a specified point from the centre - may be the edge of the hub for example.
Then the nut may cover the hole so it can be rotated forward just enough to clear the hole.
One common issue is that one bearing has not been pressed onto its register sufficiently and the hole is still in the body of the nut instead of within the castellations or "teeth" - the real issue has to be corrected - bearings pressed in properly etc. Some have been known to remove the thick plate washer or even grind it down to "cure" the problem.
When you refer to a cotter pin do you actually mean split pin which has two "legs" that are bent to lock the pin through the hole or a cotter pin which is fixed with its own nut and has a taper to hold the object in place - usually used on older or cheaper bicycle cranks as a common example.
The nut / shaft you have illustrated is usually with a split pin.
Having done a search, it seems that the term "cotter pin" is now synonymous with split pin, clevis pin etc. The wonders of progress....
