Listeners perceive the sounds of the real world to be externalized. The sound images are compact and correctly located in space. The experiments reported in this article attempted to determine the characteristics of signals appearing in the ear canals that are responsible for the perception of externalization. The experiments used headphones to gain experimental control, and they employed a psychophysical method whereby the measurement of externalization was reduced to discrimination. When the headphone signals were synthesized to best resemble real-world signals (the baseline synthesis) listeners could not distinguish between the virtual image created by the headphones and the real source. Externalization was then studied, using both discrimination and listener rating, by systematically modifying the baseline synthesis. It was found that externalization depends on the interaural phases of low-frequency components but not high-frequency components, as defined by a boundary near 1 kHz. By contrast, interaural level differences in all frequency ranges appear to be about equally important. Other experiments showed that externalization requires realistic spectral profiles in both ears; maintaining only the interaural difference spectrum is inadequate. It was also found that externalization does not depend on dispersion around the head; an optimum interaural time difference proved to be an adequate phase relationship.