DDS is a photoshop plugin you can download for free from nVidia's development tools section.
It's an output filter that generates DirectX-compliant texture files (DDS).
The Xbox's image loading routines don't look at the extension when loading a file, so a PNG could be named JPG, and it would still load correctly, which is why I tell people to name their DDS files BMP (Xbox may not care, but MXM filters out filenames it thinks are not image files based on the extension).
The settings I described elsewhere are the correct means to generate the file. Painting with Opacity is a snap in Photoshop (this is v7 I'm talking about), and the DDS filter allows you to preview it against an image background, for example, to see the opacity mapping is good.