Having clocked 538.5 hours as Spy, I think I'm well qualified to answer this question.
The Spy has 3 cloaking devices and that all 3 have different uses:
1. Invisibility Watch
The Invisibility Watch (or its cosmetic reskins The Enthusiast's Timepiece / Quäckenbirdt) is the basic, no-frills watch.
Cloak Time
It has the longest cloaking time, but also takes the longest amount of time to recharge if you're not picking up metal boxes.
Knowing the map layout and ammo drops in particular is essential to using this watch.
Decloaking and Detection
This cloaking device uses the standard decloak sound, and can be heard by enemies at close range.
While cloaked, you can be seen as a translucent outline of your current disguise when you are touched by an enemy or take damage.
Cloak restore amount:
- Small Ammo Box: 25%
- Medium Ammo Box: 50%
- Large Ammo Box: 100%
- Dropped Engineer Box: 100%
2. Cloak and Dagger
The Cloak and Dagger only drains cloak when you're moving.
Cloak Time
It has slightly less cloak time than the Invisibility Watch. The Cloak meter is automatically restored over time while you stand still under cloak (or with cloaking turned off).
As of the July 2nd 2015 patch (Gunmettle), the Cloak meter can now be restored by picking up ammo boxes whilst decloaked. Cloak gain from ammo pickup is 35% less when compare with Invis Watch.
Decloaking and Detection
This cloaking device uses the standard decloak sound, and can be heard by enemies at close range.
While cloaked, you can be seen as a translucent outline of your current disguise when you are touched by an enemy or take damage.
Usage
The C&D is the best watch for reporting enemy activity over voice chat and picking off stragglers. Just don't pick off too many, or they'll catch on and start spy checking.
It also pairs well with the Your Eternal Reward knife, as it makes finding a single target to backstab much easier, especially so when you're on RED on a Payload map. If the other team does not watch their backs, you can pick off everyone pushing a cart.
3. Dead Ringer
The dead ringer drops a fake corpse and activates cloak when you take damage.
Cloak Effects
The DR can only be used at 100% cloak meter, and when you decloak, you will have a maximum 40% charge. When activated, you receive 65% damage resistance as well as a speed boost for 3 seconds.
Depending on your current disguise, the corpse it drops is different:
- Enemy team - Drops a fake Spy corpse of your own team color.
- Your team - Drops a fake corpse of your current disguise of your own team color.
Note: As of the April 25, 2016 Patch, the fake corpse is no longer missing a Spy head, making it harder to determine whether a Spy was feigning death.
Decloaking and Detection
This cloaking device uses a loud zapping sound as its decloak sound, and can be heard by enemies at medium range.
While cloaked, your cloak is "perfect" for the first 3 seconds. After that, you can be seen as a translucent outline of your current disguise when you are touched by an enemy or take damage.
Usage
The Dead Ringer is particularly handy if you're BLU on a Payload or Attack/Defend Control Point map to make the enemy waste any sticky traps or Charged Sniper shots.
The DR is exceptionally good to use when pushing carts, as the cart refills your cloak meter very quickly.
Knowing which passages are used less on a map is a huge bonus, such as the inner track on koth_nucleus on the lower level.
Cloak restore amount
- Small Ammo Box: 25%
- Medium Ammo Box: 40%
- Large Ammo Box: 40%
- Dropped Engineer Box: 40%
Note: The 'Saharan Spy' set used to give you silent decloaks with every type of cloaking device, however all 'Item Set bonuses' were removed as of the July 10, 2013 Patch.
Best Answer
The cloak blink time is the time the spy "shimmers" and becomes partially visible after getting hit or bumping into enemy players - your 2nd guess is accurate.
0.5 seconds may not sound like a particularly long duration, but I've personally killed a lot of spies because of that blink effect and I do believe this will have impact on gameplay. Usually when I attack a blinking spy I don't 100% know where he is, just the general direction he was walking in the last time I hit him. With this, I might be able to chain my shots while the spy remains visible the whole time.