Well, you cant do alpha-blending w/ DirectDraw. Its a fact, and its unfortunately true.
However, there are some alternatives using other technologies.
Heres a really really really slow method, but itll work if you just need to alpha-blend something that you can cache and use the result over and over again:
http://www.computerhelp.forum/showthread.php?s=&threadid=80726
Ive also heard that D3D7 surfaces are fundamentally the same as DirectDraw 7 surfaces, which supposedly means that you can use D3D7 to apply alpha-blending to your DD surface. (BTW -- Youre using DirectDraw 7, not DirectDraw 9 -- they havent updated DD since version 7.) I havent personally verified this yet, but my development partner is right now looking into this for our own use. Ill post if/when its possible, but itll probably be a couple of weeks at least before I know.
What most people say to do is to just learn to use Direct3D, even if youre using a 2D app. From my understanding, your performance will be better and youll have more tricks (like alpha blending) at your disposal. There are ways to use D3D so its not too awkward doing 2D, especially if you write your own custom wrappers that only do what you want.
I kind of wish Id gone that route, but alas Ive got a pretty big codebase now all relying on DD. So, Im hoping that D3D7 surface thing works out -- otherwise, well, I might just have to rewrite my entire graphics engine in D3D9. =P
-Hiro_Antagonist