I understand "stead" to mean "in place of another", and is somewhat similar to the word "instead".

I was wondering if it would be correct to write, 

"His brother came in stead of him." instead of "His brother came instead of him."

Or does it need to be, "His brother came in his stead."?

Is the word "instead" truly formed from "in" + "stead" ?

Also, I'd like a little elaboration on how to use the phrase "(to) stand (somebody) in good stead".
It needs to be "His brother came in his stead."

Instead = 1595, from M.E. ine stede (c.1225); still often two words until after c.1640. A loan-translation of L. in loco (Fr. en lieu de).

From various online sources:

-- If something will stand you in good stead, it will probably be advantageous in the future.
-- if an experience, a skill, or a qualification will stand you in good stead, it will be useful in the future. She hoped that being editor of the school magazine would stand her in good stead for a career in journalism later on.
-- stand in good stead: Be extremely useful, as in That umbrella stood me in good stead on our trip; it rained every day. [c. 1300
-- Thus, it will be like an investment that will stand in good stead in time of dire need
-- stand in good stead, to be useful to, esp. in a critical situation: Your experience will stand you in good stead.

It's just a formal and uncommon thing to say.

Even 'cannot' is quite formal. We usually say 'can't'.

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this is late, but:

"stead" means "place" rather than "in place of another." otherwise, "in stead of another" would mean "in in place of another of another."

"instead" is truly formed from "in" + "stead"

From OED: The two words in stead = ‘in place’, rarely written as one word before 1620, but seldom separately after c1640, except when separated by a possessive pronoun or possessive case, as in my stead, in Duke William's stead. Most frequently followed by of, in the prepositional phrase in stead of, instead of (= Fr. au lieu de); formerly also in the stead of, which is still used dialectally, e.g. in the southern counties of Scotland.

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connotatively, though not denotatively, meanings are different. one meaning is for "instead of him." another meaning is for "in his stead' or "in the stead of him" (though the latter has a clunky 400 years ago British feel to it). for the latter, one can technically use "in stead of him," but that should not be encouraged, being too fiddly and unclear for most of the modern reading public.

"i sent the invitation to his house, but his brother came instead of him." in this case, the replacement of brother for him is accidental rather than purposeful. the replacement is not fundamental to the meaning. you can see the weak meaning of this "instead" because you can safely drop "of him." indeed, you can replace "instead of him" with a properly placed "oops." "but, oops, his brother came."

" i challenged him to a duel; his brother came in his stead." in this case, the replacement of brother for him is purposeful rather than accidental. "in his stead" is equivalent to "in his place" and carries connotations of intention (and sacrifice). unlike the earlier case, you can't drop "him" or "his" -- that's integral to the meaning. one can't introduce "oops" into this sentence.

" i challenged him to a duel; his brother came instead (of him)." this certainly lacks the drama of the above sentence. maybe they were drunk or maybe i mumbled and they misunderstood. "in his stead" does not allow that possibility.
I have used "stead" in this form before...

" if Tom cannot go, I will go in his stead"

a few people looked at me funny, Am I wrong saying this?
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 Clive's reply was promoted to an answer.
Thank you for this very clear explanation of the use of "stead" and "instead"! I am learning english and I came across "in the stead of" in "the Lord of the Rings" movie few days ago ; that sounded a bit formal for me at first but after a while I realized it was a sort of ancient times context and that could be understand in the kind of context! So now ,with yr help ,I know it was truly suited to the context.Cheers.Jacques.