diff --git a/.changeset/external-state.md b/.changeset/external-state.md
new file mode 100644
index 000000000..9585a11d6
--- /dev/null
+++ b/.changeset/external-state.md
@@ -0,0 +1,16 @@
+---
+"@bradygaster/squad-sdk": minor
+"@bradygaster/squad-cli": minor
+---
+
+Add external state storage — move .squad/ out of the working tree (#792)
+
+- New `stateLocation: 'external'` option in `.squad/config.json`
+- `resolveExternalStateDir()` resolves state under the platform-specific global Squad directory (`resolveGlobalSquadPath()`)
+- `deriveProjectKey()` generates a stable key from the repo path (cross-platform)
+- `resolveSquadPaths()` honors external state location
+- `squad externalize` moves state out, `squad internalize` moves it back
+- State survives branch switches, invisible to `git status`, never pollutes PRs
+- Thin `.squad/config.json` marker stays in repo (gitignored)
+- Path traversal protection on projectKey
+- 12 new tests
diff --git a/packages/squad-cli/src/cli-entry.ts b/packages/squad-cli/src/cli-entry.ts
index c875d8c42..7f21415d5 100644
--- a/packages/squad-cli/src/cli-entry.ts
+++ b/packages/squad-cli/src/cli-entry.ts
@@ -774,6 +774,20 @@ async function main(): Promise<void> {
     return;
   }
 
+  if (cmd === 'externalize') {
+    const { runExternalize } = await import('./cli/commands/externalize.js');
+    const rawKey = args.includes('--key') ? args[args.indexOf('--key') + 1] : undefined;
+    const projectKey = rawKey ? rawKey.replace(/[\/\\\.]/g, '_') : undefined;
+    runExternalize(process.cwd(), projectKey);
+    return;
+  }
+
+  if (cmd === 'internalize') {
+    const { runInternalize } = await import('./cli/commands/externalize.js');
+    runInternalize(process.cwd());
+    return;
+  }
+
   if (cmd === 'rc' || cmd === 'remote-control') {
     const { runRC } = await import('./cli/commands/rc.js');
     const hasTunnel = args.includes('--tunnel');
diff --git a/packages/squad-cli/src/cli/commands/externalize.ts b/packages/squad-cli/src/cli/commands/externalize.ts
new file mode 100644
index 000000000..df2dc3ca9
--- /dev/null
+++ b/packages/squad-cli/src/cli/commands/externalize.ts
@@ -0,0 +1,230 @@
+/**
+ * squad externalize — move .squad/ state out of the working tree.
+ *
+ * Moves all squad state to `{resolveGlobalSquadPath()}/projects/{projectKey}/`
+ * (platform-specific: `%APPDATA%/squad/` on Windows, `~/Library/Application Support/squad/`
+ * on macOS, `$XDG_CONFIG_HOME/squad/` on Linux) and writes a thin `.squad/config.json`
+ * marker in the repo. After externalization:
+ * - State survives branch switches (not tied to the working tree)
+ * - State is invisible to `git status` and never pollutes PRs
+ * - A `.squad/config.json` marker lets the walk-up resolver find state
+ *
+ * To restore local state, run `squad internalize`.
+ *
+ * @module cli/commands/externalize
+ */
+
+import path from 'node:path';
+import { FSStorageProvider, resolveExternalStateDir, deriveProjectKey } from '@bradygaster/squad-sdk';
+import { fatal } from '../core/errors.js';
+
+const storage = new FSStorageProvider();
+
+/** Directories under .squad/ that hold the actual state */
+const STATE_DIRS = [
+  'agents', 'casting', 'decisions', 'identity', 'orchestration-log',
+  'log', 'plugins', 'templates', 'skills', 'sessions', '.scratch',
+];
+
+/** Files under .squad/ that hold state (not config.json — that stays) */
+const STATE_FILES = [
+  'team.md', 'routing.md', 'ceremonies.md', 'decisions.md',
+  'decisions-archive.md', '.first-run',
+];
+
+/**
+ * Move .squad/ state to the external directory.
+ *
+ * @param projectDir - Absolute path to the project root (where .squad/ lives).
+ * @param projectKey - Optional explicit project key. Defaults to repo basename slug.
+ */
+export function runExternalize(projectDir: string, projectKey?: string): void {
+  const squadDir = path.join(projectDir, '.squad');
+  if (!storage.existsSync(squadDir)) {
+    fatal('.squad/ directory not found. Run `squad init` first.');
+  }
+
+  // Derive project key
+  const key = projectKey || deriveProjectKey(projectDir);
+  const externalDir = resolveExternalStateDir(key, true);
+
+  console.log(`📦 Externalizing .squad/ state to: ${externalDir}`);
+
+  let movedCount = 0;
+
+  // Move directories
+  for (const dir of STATE_DIRS) {
+    const src = path.join(squadDir, dir);
+    if (!storage.existsSync(src)) continue;
+    const dest = path.join(externalDir, dir);
+    // Copy contents into the external state directory. If destination files
+    // already exist, they may be overwritten by copyDirRecursive().
+    copyDirRecursive(src, dest);
+    storage.deleteDirSync?.(src);
+    movedCount++;
+  }
+
+  // Move files
+  for (const file of STATE_FILES) {
+    const src = path.join(squadDir, file);
+    if (!storage.existsSync(src)) continue;
+    const dest = path.join(externalDir, file);
+    const content = storage.readSync(src);
+    if (content != null) {
+      storage.mkdirSync(path.dirname(dest), { recursive: true });
+      storage.writeSync(dest, content);
+    }
+    storage.deleteSync?.(src);
+    movedCount++;
+  }
+
+  // Write thin config.json marker, preserving any existing config fields
+  const configPath = path.join(squadDir, 'config.json');
+  let existingConfig: Record<string, unknown> = {};
+  if (storage.existsSync(configPath)) {
+    try {
+      const raw = storage.readSync(configPath);
+      if (raw != null) {
+        const parsed = JSON.parse(raw);
+        if (parsed && typeof parsed === 'object' && !Array.isArray(parsed)) {
+          existingConfig = parsed as Record<string, unknown>;
+        }
+      }
+    } catch { /* start fresh if config is malformed */ }
+  }
+
+  const config = {
+    ...existingConfig,
+    version: 1,
+    teamRoot: '.',
+    projectKey: key,
+    stateLocation: 'external',
+  };
+  storage.writeSync(
+    configPath,
+    JSON.stringify(config, null, 2) + '\n',
+  );
+
+  // Ensure config.json is gitignored (it's machine-local)
+  ensureGitignored(projectDir, '.squad/config.json');
+
+  console.log(`✅ Externalized ${movedCount} items. State now at: ${externalDir}`);
+  console.log(`   .squad/config.json marker left in repo (gitignored).`);
+  console.log(`   Run \`squad internalize\` to move state back.`);
+}
+
+/**
+ * Move externalized state back into the working tree.
+ */
+export function runInternalize(projectDir: string): void {
+  const squadDir = path.join(projectDir, '.squad');
+  const configPath = path.join(squadDir, 'config.json');
+
+  if (!storage.existsSync(configPath)) {
+    fatal('.squad/config.json not found. State is already local or not initialized.');
+  }
+
+  let config: { stateLocation?: string; projectKey?: string };
+  try {
+    config = JSON.parse(storage.readSync(configPath) ?? '{}');
+  } catch {
+    fatal('.squad/config.json is malformed.');
+    return;
+  }
+
+  if (config.stateLocation !== 'external') {
+    fatal('State is already local (stateLocation is not "external").');
+  }
+
+  const key = config.projectKey || deriveProjectKey(projectDir);
+  const externalDir = resolveExternalStateDir(key, false);
+
+  if (!storage.existsSync(externalDir)) {
+    fatal(`External state directory not found: ${externalDir}`);
+  }
+
+  console.log(`📥 Internalizing state from: ${externalDir}`);
+
+  let movedCount = 0;
+
+  // Copy directories back
+  for (const dir of STATE_DIRS) {
+    const src = path.join(externalDir, dir);
+    if (!storage.existsSync(src)) continue;
+    const dest = path.join(squadDir, dir);
+    copyDirRecursive(src, dest);
+    movedCount++;
+  }
+
+  // Copy files back
+  for (const file of STATE_FILES) {
+    const src = path.join(externalDir, file);
+    if (!storage.existsSync(src)) continue;
+    const content = storage.readSync(src);
+    if (content != null) {
+      storage.writeSync(path.join(squadDir, file), content);
+    }
+    movedCount++;
+  }
+
+  // Remove external-state fields from config.json (stateLocation, teamRoot,
+  // projectKey) to restore true local mode. Preserve any other settings
+  // (e.g. consult, stateBackend). If nothing meaningful remains, delete the file
+  // so loadDirConfig() returns null and resolveSquadPaths() falls through to
+  // local mode.
+  let fullConfig: Record<string, unknown> = {};
+  try {
+    const raw = storage.readSync(configPath);
+    if (raw != null) {
+      const parsed = JSON.parse(raw);
+      if (parsed && typeof parsed === 'object' && !Array.isArray(parsed)) {
+        fullConfig = parsed as Record<string, unknown>;
+      }
+    }
+  } catch { /* treat malformed as empty */ }
+
+  delete fullConfig.stateLocation;
+  delete fullConfig.teamRoot;
+  delete fullConfig.projectKey;
+
+  // Check if any meaningful fields remain beyond version
+  const { version: _v, ...rest } = fullConfig;
+  if (Object.keys(rest).length > 0) {
+    storage.writeSync(configPath, JSON.stringify(fullConfig, null, 2) + '\n');
+  } else {
+    storage.deleteSync?.(configPath);
+  }
+
+  console.log(`✅ Internalized ${movedCount} items. State is back in .squad/.`);
+}
+
+function copyDirRecursive(src: string, dest: string): void {
+  storage.mkdirSync(dest, { recursive: true });
+  const entries = storage.listSync?.(src) ?? [];
+  for (const entry of entries) {
+    const srcPath = path.join(src, entry);
+    const destPath = path.join(dest, entry);
+    if (storage.isDirectorySync(srcPath)) {
+      copyDirRecursive(srcPath, destPath);
+    } else {
+      const content = storage.readSync(srcPath);
+      if (content != null) {
+        storage.writeSync(destPath, content);
+      }
+    }
+  }
+}
+
+function ensureGitignored(projectDir: string, entry: string): void {
+  const gitignorePath = path.join(projectDir, '.gitignore');
+  let existing = '';
+  if (storage.existsSync(gitignorePath)) {
+    existing = storage.readSync(gitignorePath) ?? '';
+  }
+  if (!existing.includes(entry)) {
+    const block = (existing && !existing.endsWith('\n') ? '\n' : '')
+      + '# Squad: local config (machine-specific, never commit)\n'
+      + entry + '\n';
+    storage.appendSync(gitignorePath, block);
+  }
+}
diff --git a/packages/squad-sdk/src/index.ts b/packages/squad-sdk/src/index.ts
index 12f7e2c12..f8410aecb 100644
--- a/packages/squad-sdk/src/index.ts
+++ b/packages/squad-sdk/src/index.ts
@@ -10,7 +10,7 @@ const pkg = require('../package.json');
 export const VERSION: string = pkg.version;
 
 // Export public API
-export { resolveSquad, resolveGlobalSquadPath, resolvePersonalSquadDir, ensurePersonalSquadDir, ensureSquadPath, ensureSquadPathTriple, loadDirConfig, isConsultMode, scratchDir, scratchFile } from './resolution.js';
+export { resolveSquad, resolveGlobalSquadPath, resolvePersonalSquadDir, ensurePersonalSquadDir, ensureSquadPath, ensureSquadPathTriple, loadDirConfig, isConsultMode, scratchDir, scratchFile, deriveProjectKey, resolveExternalStateDir } from './resolution.js';
 export type { SquadDirConfig, ResolvedSquadPaths } from './resolution.js';
 export * from './config/index.js';
 export * from './agents/onboarding.js';
diff --git a/packages/squad-sdk/src/resolution.ts b/packages/squad-sdk/src/resolution.ts
index 217a4f1ae..fa4bf8324 100644
--- a/packages/squad-sdk/src/resolution.ts
+++ b/packages/squad-sdk/src/resolution.ts
@@ -35,6 +35,8 @@ export interface SquadDirConfig {
   consult?: boolean;
   /** True when extraction is disabled for consult sessions (read-only consultation) */
   extractionDisabled?: boolean;
+  /** Where state is stored: 'external' when moved out of the working tree */
+  stateLocation?: string;
   /** State storage backend: worktree | external | git-notes | orphan */
   stateBackend?: string;
 }
@@ -225,6 +227,7 @@ export function loadDirConfig(squadDir: string): SquadDirConfig | null {
         projectKey: typeof parsed.projectKey === 'string' ? parsed.projectKey : null,
         consult: parsed.consult === true ? true : undefined,
         extractionDisabled: parsed.extractionDisabled === true ? true : undefined,
+        stateLocation: typeof parsed.stateLocation === 'string' ? parsed.stateLocation : undefined,
         stateBackend: typeof parsed.stateBackend === 'string' ? parsed.stateBackend : undefined,
       };
     }
@@ -528,3 +531,71 @@ export function scratchFile(squadRoot: string, prefix: string, ext: string = '.t
   }
   return filePath;
 }
+
+// ============================================================================
+// External state storage (Issue #792)
+// ============================================================================
+
+/**
+ * Derive a stable project key from a project directory path.
+ *
+ * Takes the basename of the path, lowercases it, and replaces unsafe characters
+ * with dashes. Returns `'unknown-project'` if the basename is empty (e.g.,
+ * filesystem root).
+ *
+ * @param projectDir - Absolute path to the project root.
+ * @returns A sanitized, lowercase project key suitable for use as a directory name.
+ */
+export function deriveProjectKey(projectDir: string): string {
+  const normalized = projectDir.replace(/\\/g, '/');
+  const base = path.basename(normalized);
+  if (!base) return 'unknown-project';
+
+  const sanitized = base
+    .toLowerCase()
+    .replace(/[^a-z0-9._-]/g, '-')
+    .replace(/^-+|-+$/g, '');
+
+  return sanitized || 'unknown-project';
+}
+
+/**
+ * Resolve the external state directory for a project.
+ *
+ * Returns `{globalDir}/projects/{sanitizedKey}/` where `globalDir` is the
+ * platform-specific global config directory (e.g., `%APPDATA%/squad` on Windows,
+ * `~/Library/Application Support/squad` on macOS, `$XDG_CONFIG_HOME/squad` or
+ * `~/.config/squad` on Linux).
+ *
+ * Validates the project key to prevent path traversal. Throws if the key
+ * is empty or contains `..` sequences.
+ *
+ * @param projectKey - The project key (from deriveProjectKey or user-supplied).
+ * @param create     - Whether to create the directory if it doesn't exist (default: true).
+ * @returns Absolute path to the project's external state directory.
+ * @throws If projectKey is empty or contains path traversal sequences.
+ */
+export function resolveExternalStateDir(projectKey: string, create: boolean = true): string {
+  if (!projectKey || projectKey.includes('..')) {
+    throw new Error('Invalid project key');
+  }
+
+  // Sanitize: replace path separators and unsafe chars with dashes
+  const sanitized = projectKey
+    .replace(/[/\\]/g, '-')
+    .replace(/[^a-zA-Z0-9._-]/g, '-')
+    .replace(/^-+|-+$/g, '');
+
+  if (!sanitized) {
+    throw new Error('Invalid project key');
+  }
+
+  const globalDir = resolveGlobalSquadPath();
+  const projectsDir = path.join(globalDir, 'projects', sanitized);
+
+  if (create && !storage.existsSync(projectsDir)) {
+    storage.mkdirSync(projectsDir, { recursive: true });
+  }
+
+  return projectsDir;
+}
diff --git a/test/external-state.test.ts b/test/external-state.test.ts
new file mode 100644
index 000000000..ce8ae83a6
--- /dev/null
+++ b/test/external-state.test.ts
@@ -0,0 +1,123 @@
+import { describe, it, expect, beforeEach, afterEach } from 'vitest';
+import { resolveExternalStateDir, deriveProjectKey } from '@bradygaster/squad-sdk';
+import { mkdirSync, rmSync, existsSync, writeFileSync, readFileSync, readdirSync } from 'node:fs';
+import path from 'node:path';
+import os from 'node:os';
+
+const TEST_ROOT = path.join(os.tmpdir(), `squad-external-test-${Date.now()}`);
+
+// Isolate tests from real user state by overriding config dirs
+const origAppData = process.env['APPDATA'];
+const origXdgConfig = process.env['XDG_CONFIG_HOME'];
+
+beforeEach(() => {
+  mkdirSync(TEST_ROOT, { recursive: true });
+  // Redirect global squad dir into test root so we never touch real user state
+  if (process.platform === 'win32') {
+    process.env['APPDATA'] = TEST_ROOT;
+  } else {
+    process.env['XDG_CONFIG_HOME'] = TEST_ROOT;
+  }
+});
+
+afterEach(() => {
+  rmSync(TEST_ROOT, { recursive: true, force: true });
+  // Restore env
+  if (origAppData !== undefined) process.env['APPDATA'] = origAppData;
+  else delete process.env['APPDATA'];
+  if (origXdgConfig !== undefined) process.env['XDG_CONFIG_HOME'] = origXdgConfig;
+  else delete process.env['XDG_CONFIG_HOME'];
+});
+
+describe('deriveProjectKey', () => {
+  it('lowercases and sanitizes the basename', () => {
+    expect(deriveProjectKey('/home/user/My-Cool-Project')).toBe('my-cool-project');
+  });
+
+  it('replaces spaces and special chars with dashes', () => {
+    expect(deriveProjectKey('/path/to/My Project (v2)')).toBe('my-project--v2');
+  });
+
+  it('handles Windows paths', () => {
+    expect(deriveProjectKey('C:\\Users\\tamir\\squad')).toBe('squad');
+  });
+
+  it('returns "unknown-project" for empty basename', () => {
+    // path.basename of root returns ''
+    expect(deriveProjectKey('/')).toBe('unknown-project');
+  });
+});
+
+describe('resolveExternalStateDir', () => {
+  it('creates the projects directory', () => {
+    const dir = resolveExternalStateDir('test-project-123');
+    expect(existsSync(dir)).toBe(true);
+    expect(dir).toContain('projects');
+    expect(dir).toContain('test-project-123');
+  });
+
+  it('returns path without creating when create=false', () => {
+    const dir = resolveExternalStateDir('nonexistent-project-xyz', false);
+    expect(dir).toContain('nonexistent-project-xyz');
+    // May or may not exist depending on prior runs — just check the path is sane
+    expect(dir).toContain('projects');
+  });
+
+  it('is idempotent', () => {
+    const dir1 = resolveExternalStateDir('idempotent-test-proj');
+    const dir2 = resolveExternalStateDir('idempotent-test-proj');
+    expect(dir1).toBe(dir2);
+  });
+});
+
+describe('SquadDirConfig stateLocation', () => {
+  it('loadDirConfig parses stateLocation: external', async () => {
+    const { loadDirConfig } = await import('@bradygaster/squad-sdk');
+    
+    const configDir = path.join(TEST_ROOT, '.squad');
+    mkdirSync(configDir, { recursive: true });
+    writeFileSync(path.join(configDir, 'config.json'), JSON.stringify({
+      version: 1,
+      teamRoot: '.',
+      projectKey: 'my-project',
+      stateLocation: 'external',
+    }));
+
+    const config = loadDirConfig(configDir);
+    expect(config).not.toBeNull();
+    expect(config!.stateLocation).toBe('external');
+    expect(config!.projectKey).toBe('my-project');
+  });
+
+  it('loadDirConfig defaults stateLocation to undefined (local)', async () => {
+    const { loadDirConfig } = await import('@bradygaster/squad-sdk');
+    
+    const configDir = path.join(TEST_ROOT, '.squad2');
+    mkdirSync(configDir, { recursive: true });
+    writeFileSync(path.join(configDir, 'config.json'), JSON.stringify({
+      version: 1,
+      teamRoot: '.',
+      projectKey: null,
+    }));
+
+    const config = loadDirConfig(configDir);
+    expect(config).not.toBeNull();
+    expect(config!.stateLocation).toBeUndefined();
+  });
+});
+
+describe('resolveExternalStateDir security', () => {
+  it('rejects path traversal in projectKey', () => {
+    expect(() => resolveExternalStateDir('../../etc/passwd')).toThrow('Invalid project key');
+  });
+
+  it('rejects empty projectKey', () => {
+    expect(() => resolveExternalStateDir('')).toThrow('Invalid project key');
+  });
+
+  it('sanitizes special characters in projectKey', () => {
+    const dir = resolveExternalStateDir('my/project\\name');
+    expect(dir).toContain('my-project-name');
+    expect(dir).not.toContain('/project\\');
+  });
+});