What does it mean when a friend's activity ring is greyed out?

Yes those people who have stopped sharing with you (tapping on Hide my Activity) will appear at the very end of the Sharing section, under the title THESE PEOPLE ARE CURRENTLY HIDING THEIR ACTIVITY DATA FROM YOU.

That is just a toggle though. If they start sharing again, all their data becomes visible to you right away again.

So I dont think that happened here. Its more likely a case of not wearing the watch for a while, or not being connected to network. Are you in the same timezone? That can have an impact too.

Yes you will get notified differently in those cases. Same is true if your friend starts hiding activity.

If somebody removes you, that person just disappears from the view altogether.

Grey basically means there was no activity recorded during that day. Typically something like watch was not worn at all. Could it be that their workouts shown there may come from another time - not necessarily that same day.