It almost seems to me that Memory might be your biggy problem... Or a Bad IDE Cable for the CDROM and or HD.
But, the Preference of C:\\I386 or C:\\Windows\\Options\\I386 is merely a matter of choice. The reason I put them there is to make it so all my drivers and updates I want to put on the machine are all there. Also the Diskette is a Great one to have in your "Arse"nal anyway.
Therefore, just a matter of consolidation and standardization.
Back to your real probs, Still I'm betting it's memory. Take out half of it and install. If still Flaky, swap the other half in. Careful with static and all...
More responses will generate more replies... ;)