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Yeah, I play games directly off of my external HDD using a Y cable sometimes, and I've never had an issue with it. You can use an HDD with an external power source, but the Y cable is easier since that's one less cable going into an outlet. You have to plug the HDD into the Wii U's USB slot anyway, so you might as well use the one right next to it.

As far as size goes, unless you got started really late and plan to go buckwild on exclusive games in the eShop, you really don't need much HDD space. I have a ton of indies and some retail games downloaded, and I'm only using about half of the 500 GB drive I have.