You can make the sword part of the character's sprite if you want. The main advantage of having a separate sword sprite is that you can extend it beyond the square area of the character sprite.
<img src="http://i396.photobucket.com/albums/pp45/Elyzius/big_sword.jpg" border="0">
If you look carefully at the above picture, you will see bits of cyan color behind the sword. The cyan color is actually part of the sword's collision mask, which I purposely kept visible for demonstration purposes.
If you decide to make the sword blade separate from the character, you should set its sprite's origin to the bottom center of the blade.
<img src="http://i396.photobucket.com/albums/pp45/Elyzius/sword.jpg" border="0">
Likewise, the sword's collision mask should also have its origin at the bottom center.
Next, edit every frame of the character's animations to create an image point where the sword blade and its collision mask will be attached.
<img src="http://i396.photobucket.com/albums/pp45/Elyzius/imagepoint.jpg" border="0">
Finally, create events to attach everything together at the proper angle. Rather than explain the process step-by-step, I prefer to upload a demo CAP file for anyone to look into.