I recently purchased the dragon and I'd like to hear from people who already used it how it performs on the battlefield. What tactics to use and which upgrades are the most useful? Should I take only one option or two? Is 'Breathe Fire' as good as it looks on the paper? How to counter the 'Survival Instinct'?

Breathe Fire does indeed look good on paper, but I don't like it; I'd rather save the Will to pass those Courage tests.

The best ability is Fly, as it allows you to use the Dragon most effectively. A flying Dragon can get into combat quicker, escape from danger easier, avoid obstacles, and has a greater selection of targets. Always get this ability.

Wrymtongue (I think that's what it's called) is another that looks good on paper, but in reality a Dragon is more than capable of dealing with the vast majority of threats posed by enemy Heroes. It doesn't need any more help.

Tough Hide is nice, as it makes your Dragon more survivable. However, with seven Wounds a Dragon is already pretty tough. I'd save the points for something else.

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"There are few left in Middle Earth like Aragorn, son of Arathorn." - Gandalf, Many Meetings

The one time I used the dragon I gave the Breath Fire upgrade and Tough Hide, he was difficult to kill but I had way to few soldiers to back him up.
And once I used all my will to breath fire he was gone pretty fast, because of the survival instinct.

Most of the people who used a dragon use Fly and Tough Hide as far as I know (the people who I've played against).

In this case I think I'll just use a budget Dragon of 300 points with flying using the extra 50 points to bring more Goblins into the fight and spending the Will to stop him from running away. Thanks for the advice.

Also- had any of you been surprised by how small he is? I mean the cave troll could strangle this guy!

Yeah, they had to fit it on the base and make it playable. Maybe they're saving the mumak-sized dragon model for Smaug.

It's not as bad as the Cave Drake, which is meant to be able to swallow people whole..!

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"There are few left in Middle Earth like Aragorn, son of Arathorn." - Gandalf, Many Meetings

I think the benefit of Tough Hide is not so much the extra wounds, but rather the defensive increase*. Being by 2, it reduces the chance of every wound and the annoying Survival Instinct and does a lot to protect against Elven archery. Still, a lot of points and equivalent Goblins may be better but it can be quite useful at times.

*Having not checked the warbands book, I'm not sure if rules have changed.

You're right about the defence bonus- TH does add extra two points.