Actually, yes, you are missing something obvious. But then again, it's not that obvious, so I'll cut you some slack. :-)

Kidding.

More seriously, the problem with all email is that there are two basic "languages" that can be used to compose a message: rich text with colors, embedded images, etc., and plain text that lacks bold, italics, and similar. If you're stuck in plain text then you'll never even see the button you need to click, but if you're able to send rich text, you'll be surprised by all the capabilities you have when composing an email message.

Let's have a look, shall we?

First off, if you click "Compose" and see the following, you've a problem:

See below the subject where it says "Rich formatting >>"? Click on it and an entire ribbon bar of options show up, including bold, italics, underline, choosing different fonts, choosing font size, color, highlighting, adding smileys and other emoticons and more:

As you can see, I'm in the midst of sending an email about my kitchen and already have a space ready for an image. To add an image I need to click on the "add picture" (highlighted above) after clicking in the message at the point where I want the image to be added. A selection dialog appears:

No surprise, to proceed further, click on "Choose File" and you'll get a standard file selection dialog box:

Lots of different images and files visible, as you can see. To proceed, I find the image file I want to upload and include and click on "Choose" on the lower right:

Looks like just the image I want to include, so I click on "OK" and after a moment or two, it adds the image to the message.

Before you're done, click on the image and look at the menu that pops up on the bottom:

I encourage you to click on the different sizes and pick the one that is the smallest possible that conveys what you want to share with your recipient.

So that's all there is to including images in your Gmail messages! While you're playing around, I encourage you to check out all the many, many formatting options you have available while composing messages too. Can make 'em look quite a bit more fun.