For normal use, you want cold water to enter your tank at the bottom, and hot water to come out of the top.
One way to know if you have the bottom valve in the right position is to open your hot water heater overflow valve, and if you get water under pressure flowing out then you know you have the bottom valve in the right position.
Next, turn on your faucet and if has water flowing you should be good to go... with one exception. You don't want cold water bypassing your hot water heater.
Normally, I would think when you have both valves in the right position as determined above, then it it impossible for cold water to bypass the HWH. However, that may depend on your valve type and I can't tell from your drawing what you have.
AND FINALLY... if you can't get any hot water to your faucet, then you probably have a stuck check valve.
These are those brass nipples protruding out the back of your water tank, and you can have 1 or 2. If these are broken or frozen shut, I would remove them... drill their guts out... and put the nipple back.
...Or buy a replacement check valve if you have access to one. Most of the time these things fail when you are camping and you lose your hot water or your hot water starts to pulse, which isn't fun.
Note: If you remove the plastic pipe you will see a "donut" washer you need to reuse. And these things sometimes don't seal the second or third time around. So I always carry a spare. And be sure you don't over tighten the plastic or it may crack.
Further, that brass nipple may be on so tight a 1" or 1-1/16" crescent wrench (I can't remember the size) may not give you enough leverage, so you may need to go to HD or Lowe's to buy a $10 wrench long enough to apply enough torque.
For more information you can do a search on this subject.
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