I'm releasing an upgrade today that many people have asked for over the last few months (and which I am glad to have finally finished to programming on). This is the "Favorites Only" entry - meaning that you now have a third option for privacy on your entries.
Whereas before there was only private or not-private (public) entries, now there is another choice - Favorites Only. A Favorites Only entry will only appear in your diary to people who are on your Favorites list (and to you).
When you go to write an entry, you will notice that the Private Entry checkbox has been replaced with a dropdown list. This lists three selections: Public, Favorites Only, and Private. Just select the privacy option you want for the entry you are posting.
Favorites Only entries will appear in the table of contents for your diary with an "(f)" next to them, like the "(p)" next to private entries. As I said, people on your Favorites list will be able to see them, and you will too - but to anybody else they will be invisible (like a private entry is). They won't appear on the table of contents, or on the previous and next links in your entries, or in your notes page, unless the reader is one of your Favorites.
Favorites Only entries also will not appear on the front page or in Recent Entries, and (like private entries) can not be nominated for Reader's Choice.
You can also change the privacy setting in the Entry Manager - there you will find a dropdown list like the one on the entry editing screen, instead of the checkbox that used to be there. Through the Entry Manager, you can set blocks of entries to different privacy levels.
I think that covers it - for all the work that went into it, it doesn't sound like much. Enjoy!
Answers to later questions: