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I have heard it is possible to simulate a GPS location with a developer option. However people get banned from Pokémon go, if they fake their location.

Is this because an app knows, when it's a simulated location or did the people just fake it bad enough?

Motte001
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An app can detect when mock locations are enabled. It's quite simple to do. See https://stackoverflow.com/q/6880232/4107809.

Community
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mattm
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    It's not simple, if there is an app hiding the fact that another app is mocking a location (like some xposed modules, MockMockLocations and Hide Mock Location) – GiantTree Jul 17 '16 at 14:10
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    Enabled != using. But I think the app dev don't care and ban in such case. "normal users" don't even know about developer options – Motte001 Jul 17 '16 at 15:23