The inline attachment only works for things you have actually attached.
So... first you have to attach the image.
Assuming your basic editor looks like mine...
You look below the compose field, click 'Choose File'
That opens up a browser pop window for your harddrive where you find the image that is on your computer. You find it and double click (or click file and click open), tick the box (in the message board interface) that says 'Inline' and then click 'Upload attachment'. (You can also tick the box that says 'inline' after you upload if you forget to do it before.
Then you write the code for the inline attachment using the name of the jpg you just uploaded.
NOW... in order for an image to be displayed within a post here at TORn it must conform to size guidelines. That means, for SCOD, you need to download the image you wish to discuss and change the size to one that conforms to the guidelines here. If you are not comfortable with that procedure, then you should just link to image at the LOTR Screencap Library as you did.
USING THE URL CODE: you could do this if you have an image that conforms to TORn's guidelines and is hosted at a site you own. You cannot embed the image you see at the LOTR Screencap Library for two reasons:
one... it's too large
two... embedding that image that is hosted on a site you don't own is considered hotlinking and is not good netiquette. (a site you 'own' can include an image in your own account at sites like photobucket, picasa, etc.)
sites often have mechanisms in place to prevent and/or punish people who hotlink images that are hosted on their site. The LOTR screencap library does not allow hotlinking and will substitute a 'anti-hotlinking' image in the place of the one you are trying to display.
Let me know if there are parts of what I've provided that you'd like more clarification on or have other questions.