With this option checked, DropDMG will only require free disk space on the destination volume equal to the size of the final disk image file. This can make disk image creation much slower, however. Additionally, when creating an encrypted disk image, all data written to the destination volume will be encrypted.
With this option unchecked, disk image creation will generally be much faster (and the final compressed disk image file may be slightly smaller), however DropDMG may require working space on the destination volume of up to twice the size of the source folder. When creating an encrypted disk image, the final disk image file will be encrypted, however temporary files will not. Thus, if you plan to distribute the destination hard drive itself (rather than just the final .dmg file), you should use Disk Utility to Erase Free Space securely.
Leaving Use less temporary disk space unchecked is generally the best choice, unless there is little free space on the destination volume.