you can use a duel layer DVD, or a 8GB flash drive.
Look on MS's website for the "Windows 7 USB/DVD Download Tool" which makes the whole process of moving an ISO to a DVD or flash drive much simpler (or in my case I used it for windows 8, and I suspect it would work for just about any ISO)
make a new partition to install win7 on first.
I used the same method as listed on the site to install win7 to a disk that already had XP pro x64 on it. It was easy and worked. you can dual boot or just use c:\ as a recovery partition when done.
you can sometimes install straight from the mounted iso, but it doesn't always work / work the way the you want it to. The main reason I installed using the method I listed was to create a recovery partition in the process. Makes life much easier if your OS gets screwed up. You can follow the same method to install from an external drive, just mark the external drive partition as active first and change the boot order in the bios to boot the external drive before the internal HDD.