Option 2 is correct.
The nested list should be inside a <li> element of the list in which it is nested.
Link to the W3C Wiki on Lists (taken from comment below): HTML Lists Wiki.
Link to the HTML5 W3C ul spec: HTML5 ul. Note that a ul element may contain exactly zero or more li elements. The same applies to HTML5 ol. The description list (HTML5 dl) is similar, but allows both dt and dd elements.
More Notes:
dl= definition list.ol= ordered list (numbers).ul= unordered list (bullets).
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