I have just converted a file using your suggestion and it went from 308 MB to approximately 260 KB.
That sounds like the conversion failed. If you really mean "KB" above, and not "MB". Did you activate the DSP in the Conversion Options dialog? This is different than the standard DSP. It's separate. You have to set it up for your conversion. It ignores the standard DSP settings.
Another question if you would be so kind is that when I go into options->DSP output->Sampling rate I selected "change all". I see that when I play the original DFF file it is resampled to 352,800, which I get, but when converting isn't the original DFF sampling rate 2.8224 MHz? Does this mean that to convert the file it is first being converted to PCM?
I'm not 100% clear on why 2.8 MHz becomes 352.8 kHz during conversion, but that's definitely what happens inside of MC. I get the idea that this is the standard, normal way of converting from DSD to PCM. ...and yes, when you convert from DSD to any other format using MC, it definitely becomes PCM first. AIFF, FLAC, WAV, etc are all PCM based formats. Further, MC doesn't include any way to manipulate DSD files without first converting them to PCM. I think some programs claim to manipulate DSD without going through PCM in the middle, but I'm skeptical.
Also wouldn't it be better to convert to 88.2 KB, 2.8224 MHz/32 = 88.2 KHz?
By some theories, yes; by other theories, it doesn't matter. I don't have a strong opinion either way because I haven't done any testing or done any research into others doing the same thing. I would expect they would both be very high quality. You could certainly convert a few files to both rates and do some listening. But we all know that these types of tests are hard to do in a way that's meaningful.
Good luck!
Brian.