1. create the graphic you want to use… preferrably work on a 32 x 32 pixel image
2. size it to 16 x 16 pixels
3. change the color mode to indexed
4. export it using the Gif89a plug-in or photoshop’s built in “save for web” and make the background color your knockout color.
5. save this file as a gif. then close the file
6. re-open the file, and now, simply “Save As” and choose “windows icon, ico”… VOILA you have a transparent favicon.ico file 
7. copy favicon.ico into your main blog directory and the directory with the header.php file.
8. You will now need to edit your header.php (between <head> and </head>) of your wordpress blog. Add the following code:
<link rel=”shortcut icon” href=”<?php bloginfo(’template_url’); ?>/favicon.ico” type=”image/x-icon” />
Best as following example, between:
<link rel=”alternate” type=”application/atom+xml” title=”Atom 0.3″ href=”<?php bloginfo(’atom_url’); ?>” />
<link rel=”shortcut icon” href=”<?php bloginfo(’template_url’); ?>/favicon.ico” type=”image/x-icon” />
<link rel=”pingback” href=”<?php bloginfo(’pingback_url’); ?>” />