Setting 1 has the thin sides of the peg board and the pin board together. Setting 2 has the thin sides of both boards facing the same direction. Setting 3 has the wide sides of the boards together. (ed. Setting 3 is only possible with the boards in a straight line, not in the round.) Each of the settings moves the pegs and the pins further apart.
The looms come with spacers that are 1/32" of an inch thick which can be placed in between the boards, so you can fine-tune the gauge of your knitting.
This swatch shows the difference between basic setting 2, and adding a single spacer to slightly increase the stitch gauge.
The knitting on the left is at Setting 2, with 4"= 12 stitches and 15 rows. The knitting on the right is at Setting 2 with 1 spacer, and 4" = 11-1/2 stitches and 14 rows.
This swatch shows the other end of the extreme: the difference between basic setting 2, and adding 32 spacers (1" worth, about the maximum extent the bolts allow) to greatly increase the stitch gauge.
The knitting on the left is at Setting 2, with 4"= 12 stitches and 15 rows. The knitting on the right is at Setting 2 with 32 spacers, and 4" = 8 - 9 stitches and about 4 rows.
The nice thing is that I was able to add the spacers to the loom without needing a row of waste knitting or even removing the knitting from the loom. I can see this being very handy when knitting things with borders such as sweaters. Many sweater patterns call for a specific size needle when knitting ribbed edges then switching to a needle one size larger to knit the body and sleeves of the sweater. With these looms, you can knit the ribbed edge, then slip in a spacer or two before knitting the rest of the piece.