It says it works with a usb pendrive or a usb harddrive Installing Windows 7 on to USB flash drive or hard drive Step 1: Kick start the procedure by connecting your USB flash drive or hard drive to your Windows 7/8 PC
It also says "Please backup all data before continuing further, as the drive will be erased." I can't format my external HDD because I got 900 gb data in it. Is there any other way?
I don't think so. If you are doing all this to just get the Hardware ID registered on the computer for Windows 10 for future use, it is far less work to just upgrade your Window 8.1 to Windows 10 then rollback to Windows 8.1 afterwards. Windows 7 isn't really designed to be installed on an external usb drive and will be painfully slow to run. It would be easier to install a dual boot on your hard drive if you have enough space to shrink for a new partition or add another hard drive for that purpose. You could install it to an external usb drive with VMware by designating the external drive as the VM hard drive. But this will only get an activation for the VM itself as that is what windows will see as the hardware.