Paraphrasing uses the ideas from a source without using the same words of the source.
Citation needed? Yes!
When to use: Most of the time, especially for your secondary sources (in this case, your researched sources rather than the short stories).
The "bad paraphrase" examples very closely follow the source material. Sometimes a word is out of order, and there are usually synonyms used... but that's not enough to put an original twist on the material. The highlighted text calls out where the phrasing in the original and the bad paraphrase closely resemble (or exactly match) each other.
The "better" paraphrases try to summarize more rather than repeat every detail with different words. Each one pulls a little bit of extra info from the source, beyond what's copied on this page, as well, which helps makes them better, too: we're not mimicking one or two sentences, we're processing more of that work to make it work for our own purposes.
Direct quotes use the exact wording of a source to bring the ideas into your own work.
Citation needed? Yes!
When to use: If the original wording is very, very good or significant (e.g. you're discussing a character's word choice, perhaps), quote it. Don't overquote: keep the juicy bits as excerpts. Don't quote entire sentences (usually). Remember to include your own commentary/justification for including the quote.
Quoting too much is a common bad habit, as is neglecting to integrate a quote into your own writing. The shorter your assignment, the shorter and fewer your quotes should be. Even if you've documented your sources, a paper that is mostly direct quotes doesn't actually show your thought process and wouldn't be considered original.
Always remember to add commentary about what's significant about the quoted material -- don't let quotes stand on their own. Integrate them into paraphrases that help hold them up, or at least make the sentence the explanation. (Don't summarize the quote, though! Unless it's an especially dense and horrible sentence, your reader probably understood it and doesn't need it restated.)
In the examples below, note the quantity and proportion of the highlighted text around the quoted material.