DDS stands for DirectDraw Surface, and is used in a lot of games as textures and other images. They function pretty much like a regular image file, and some of them will hold alpha maps.
Adobe Photoshop Plugin:
(if you know of a plugin for a different image editor, please let me know and I will add it to the list)
Once you have the plugin, you will be able to open and save DDS files. As an example, I will open:
If you get this popup, you can simple click off "Show this dialog" and then "OK", or else you will get that every time you open a DDS file.
Now you get the large image frame showing up. If you hit "Channels" and then click on the "Alpha 1" you will get the alpha channel, which basically lets parts of the image be see-through. Black is 0% visible, white is 100% visible, and perfect grey would be 50% visible; you get my drift.
Now, when you are saving it, we will want to do a Save As... so that we don't overwrite this original file. You should save it under your mod folder, though exactly where is really dependant upon your mod itself.
When you hit "Save", you will be greeted with the following window.
The only things that you really need to worry about here (of course I could totally be wrong, so let me know if I am) are:
1) The very top-left dropdown box. This selects which format you want your DDS file to be in. At the very top are two "DXT1's". One has an alpha layer, and one does not. As it pretty much shows, one will save your alpha layer, and the other will not. Even if you don't have an alpha in your original image and choose a format that has one, that shouldn't affect what your file does in-game. This format makes a small file size, but in very bad quality.
2) The MIP Map Generation section. You pretty much want this on when doing textures that will be applied for models, but you don't want it on if you are simply doing user-interface work, and things like that that do not make use of MIP mapping. (Thanks to Colonel_Jessep for this one)
Down to "DXT5", this is what I used to use, although the image height and width need to be of a multiple of 4.
What I have been using lately is "184.108.40.206 ARGB." It creates very large image sizes, but the quality -- as far as I can tell -- is 1:1. I am sure that there is a really good comparison of the formats somewhere. I am not sure what GPG uses, and it may not even be on that list as I was not able to emulate the correct file size.
Well, once you choose one and hit Save, all should be good and saved, and you now have your DDS file.