SMF is Simple Machines Forum, it's the software this forum runs on.
No, it can be smaller, 125x125 is the max. If you upload something bigger the forum software will try to resize it. Usually works, but sometimes it borks. JPEG and PNG are fine, GIFs work, but you have to get the file size down and I do not know what the limit on that is.
I see you've got your avatar now. It would be helpful to somehow let people know that they can't use the URL option, but I'm not going to rewrite the forum software or anything.