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What does this option in Terminal do?

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It seems to have no effect on anything.

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Essentially, this option prevents other applications (including things like TextExpander) from "listening in" on what you are typing. By preventing other background processes from recording or accessing your keystrokes, you are ensuring they cannot be logged or monitored, eg. by a simple keylogger, or another program running with normal permissions for potentially malicious purposes.

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    I wouldn't bet on the keylogger part. After all there is still data flowing from the keyboard to the computer which can be intercepted on a lower level (or even the wire). – nohillside Nov 5 '12 at 5:31
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    While that may be true, it prevents many of the popular software-based keyloggers for OS X, such as logKext, by ensuring only the foreground process receives input at the OS level. – Yasyf Nov 6 '12 at 1:18
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Here is a screenshot from the help menu.

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There's a great answer about it on the Security Stackexchange

"Secure Keyboard Entry" maps to the EnableSecureEventInput function whose concept is described here. Basically, applications don't access the hardware themselves; they obtain events (e.g. about key strokes) from the operating system. Some elements in the OS decides what application gets what events, depending on its access rights and GUI state (there are details depending on which application is "in the foreground").

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