That sounds like 3 to me...a mixture of sin and righteousness.
What cancels out the sin?
The sin already committed is absolved and the future sin is gradually conquered through unfused grace.
The reason I objected to (3) is because the way you put it is works salvation: a sin is canceled by good works. The sin is conquered — not merely committed and canceled — by man’s acceptance of sanctifying grace. But sin is certainly something that coexists with righteousness in a baptized person, so to that extent (3) is not incorrect.