A software firewall has two functions.  First - to stop inbound traffic that you don't want.  Second, well, to stop outbound traffic that you don't want.  There are quite a few online port scanners that will look at your computer and tell you which ports you have open.  Be careful of these as they may be e-mail address harvesting schemes or might put spy/adware on your computer.

There are two types of firewalls, one is a piece of software that you load on your computer "personal firewall".  The other is a "little black box" that sits in between your computer and your internet connection.  Windows XP (with SP1) has a built in firewall, and it is adequate in most cases.  Some Win XP users still use a separate personal firewall due to extra features included in most of them. Most home users (that have one single computer) will use a software firewall. It is important to note that a personal firewall can enforce "application permissions" and a hardware firewall cannot - that is the main advantage.  This means you can control your computers access to the internet by PROTOCOL and BY APPLICATION (Word, Excel, Lotus, Acrobat, etc...).  I've done this with Zonealarm and Sygate in the past and now I am using the Windows firewall.

I would recommend two firewalls - a personal software and a hardware one.  The hardware firewalls are very effective at blocking all inbound traffic and are very low cost.