find a program called Partition Magic, using the free space on your hardrive create a partition for linux that will be later repartioned into diffrent sections. Then when it comes to the linux setup, install linux on that partition and your set.

heres a visual depiction of what the partioning might look like:

Before:
[----------WINDOW XP NTFS PARTITION 80 Gigs--|--Fee Space--------]
Before Install, After First Partion:
[----------WINDOW XP NTFS PARTITION 60 Gigs] [---EMPTY PARTION--]
After linux Install, Repartitioning the Empty Partition Space:
[----------WINDOW XP NTFS PARTITION 60 GIgs] [-/root][/home][swap]

Notice how you took the free space from your hardrive and created an empty partiton, then while installing Linux you used the empty partition you created to break into smaller sections.

Hope that helps, Linux will manage the booting between windows and linux.

And it is possible to do this off of my EXTERNAL USB drive?

You might not want to install it to an external drive because when you install linux it will install LILO. LILO is used to to select the operating system you want to boot off from. You can get around and not install LILO but then you will need a floppy to boot up to get to linux, which makes it a pain unless you dont mind. Check out this site, it is for a linux that runs completely from a CD, so no install is required. http://www.knoppix.net/