Found this... it seems a more concise explanation, so I will post the relevant portion:
Transparent HL textures In Wally
***********************By NinjaGrinch
Any part of the texture that you want to be transparent needs to be the same color as palette index 255. Generally its a good idea to use a specific color like pure blue/green/red or my favorite, magenta RGB(255,0,128), that stands out from the rest of the texture.
The best way to set the color you want to index 255 is to first get the image looking how you want in Photoshop (or whatever your prefered graphics program is), then open it up in Wally.
Pick the color you want to be transparent (Use the "Eye Dropper" tool to select the transparent colour as your primary colour.), then choose 'Translate Colors' from the Colors menu. For 'Source pixels' enter the index number you noted, then put 255 for the 'Destination Index' and CHECK the box 'Swap Indexes'.
Full thread here:
http://www.chatbear.com/unity2/668/403,1064167071,2615/536206?v=flatoldAnd finally another helpful Transparent Textures HL tutorial, this one with pretty pictures at Egir.dk:
http://www.egir.dk/index.php?page=wal_transparent/wal_transparent.html