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Playing as a Halfling Rogue, when buying weapons do I only take from the small category for weapon damage without penalties? Could I use a medium sized rapier? Shortsword? How can I tell which weapons are fine for me to use, and which are too big?

I don't exactly understand how this item works...Does this item apply to normal D&D 3.5 rules? Or does it use a different set of rules... Basically I'm trying to understand exactly what this thing does, a permanent +2 to ac? Or does the opponent always have to reroll when he does a critical hit...