under your text area, there's a light blue box that has three fields... the first of which is a field with a button that says "browse" - clicking on that button will open up a folder on your own machine, where you'd then browse for your image.
after choosing the image, you go to the next box, that says "title" - of course, this is optional, but here is where you'd put the title of the image, example: "Three Apples" (minus the quotation marks).
The final box is the description box, also optional, but befitting for a full sentence of what the picture is of.
Then you'd click on the button that says "upload"
After it's uploaded, you'll see a thumbnail of the image in that same area.
You click the image, and 5 options pop up.
The first one allows you to choose from full size or thumbnail size (click on it to change the option)
The second allows you to choose whether or not the image links to anything (again, click to go through and select and option)
The third says "Send to editor" - when you click this, it will automagically place the image, with your settings back up in the text box wherever you last had your cursor.
Then you hit "save" or "publish" and you're done.
So yes, you would have to put it on your machine, as I'm thinking that hotlinking to yahoo is disabled (by yahoo).
Did that clear it up enough?