Board Thread:M.U.G.E.N Help/@comment-31722189-20151229222057/@comment-3495717-20151230003026

You need to index the sprites, a process that basically forces a 256-colour palette onto an image and allows you to define the transparency colour. I recommend downloading Photoshop CS2 if you haven't already; it's legally free and is capable of indexing images (in batch, no less!).