In the simplest views, VMware creates a container for you. The answer to the question "where will I install the XP/Vista?" is "inside the virtual container". To your host, the virtual machine appears merely as a set of files. To the guest, when Workstation is running, it appears as if it were running on real computer hardware.
You will definitely want to read through the user manual and the guest OS installation guide manual as well. At least peruse them to get some understanding of this complex technology... it will help answer many of the questions you undoubtedly will raise.
