A true "virtual directory" means that the content is not actually physically located under the web root path - it's somewhere else and is mapped so it's accesible via HTTP. For example, let's say you have the default web root at C:/inetpub/wwwroot, and some Office files located at D:/files. If you wanted to make these available, you could create a virtual directory named "office" and map it to D:/files. Your users could then go to http://servername/office and browse those files - note that C:/inetpub/wwwroot/office does not exist. This is a virtual directory, and has nothiing to do with application settings.
-Tom