An avatar can either be a gif image or a Shockwave Flash file. The file needs to be named either "avatar.gif" or "avatar.swf" as appropriate.
If you avatar is a swf file, you may have more than one frame within the file. Truth be told, the swf could really be pretty complicated with animation, etc. if desired. To control what portion of your avatar is displayed during a chat, you will need to include labels in the Flash animation. When you send a chat message, your avatar on each recipients system will parse the message and see if any of the words in the message match any label names in you swf avatar. For the first match found, that word is removed from the message and the Flash animation goes to that frame.
The chat movie will scan your Flash file and look for labels. The labels will be then presented to the user in a simple picker where they can transmit the emotion or mood to others on the chat. If you don't want a Flash label to appear in the list shown to the user, start the label name with a "#" character.
Once you make your avatar graphic, place it in the dswmedia folder next to the Shockwave system player (the dswmedia folder doesn't appear to exist by default, but needs to be created). The system player is located in the System:Extensions:Macromedia:Shockwave folder on the Mac, the Windows\System\Macromedia\Shockwave folder in win95/98, and the WinNt\System32\Macromedia\Shockwave folder on WinNT.
When you log onto a chat, your avatar is propagated to all other participants for that chat session only. Once you log off (or they log off) it dissapears from their system. Your avatar is yours and yours alone to create and control, so there is no set standard for naming Flash frames, etc. The only thing to bear in mind is that your avatar is sent to everyone (and theirs to you as well) each time you log on, so keep it small in size (the default netBuffer size for the MU server is only 16k anyway). The avatar I have for myself currently is 889 bytes. Also, keep its dimensions small. There will be an imposed size limit of no greater than 50x50 pixels, so the avatar will be scaled if its too big, meaning if you make it bigger, you're just wasting bandwidth.