Dragon Dagger is a Dragon Tier weapon (Higher than Rune and Diamond) it has a base damage of 7, and can be poisoned to make it a Dragon Dagger (p) or DDS, you place 4 fermented spider eyes in a linked + around the the dagger.
Dragon dagger is dropped by Guards, rarely.
Dragon Dagger can also be used to block arrows and fireballs, but it is a far smaller chance because it is so small.
The drop rate depends on version (Hardcore or standard) Hardcore means it is 100x less common.