That freewheel is what we're talking about, although having done this conversion a lot, I can say that you should shell out for the Shimano freewheels (~$20). The cheap ones aren't worth spit.

You won't be able to ride the bike after converting without dishing the wheel. You are correct that a new wheel is an option, and can probably be had in the $50 range (+$20 for a freewheel).

As for the locknuts, they're supposed to be tight - keeps the wheel on the frame, especially with semi-horizontal dropouts. You just need to honk on it.