Well, you can't do alpha-blending w/ DirectDraw. It's a fact, and it's unfortunately true.
However, there are some alternatives using other technologies.
Here's a really really really slow method, but it'll work if you just need to alpha-blend something that you can cache and use the result over and over again:
http://www.xtremedotnettalk.com/showthread.php?s=&threadid=80726
I've 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 -- You're using DirectDraw 7, not DirectDraw 9 -- they haven't updated DD since version 7.) I haven't personally verified this yet, but my development partner is right now looking into this for our own use. I'll post if/when it's possible, but it'll 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 you're using a 2D app. From my understanding, your performance will be better and you'll have more 'tricks' (like alpha blending) at your disposal. There are ways to use D3D so it's not too awkward doing 2D, especially if you write your own custom wrappers that only do what you want.
I kind of wish I'd gone that route, but alas I've got a pretty big codebase now all relying on DD. So, I'm hoping that D3D7 surface thing works out -- otherwise, well, I might just have to rewrite my entire graphics engine in D3D9. =P
-Hiro_Antagonist