I've usually heard observing described as simply not following your thoughts, and letting them pass, possibly even "labeling" them. Not getting caught up in following them. When I meditate, I'm constantly becoming aware that I'm lost in thought, over and over again. So when I realize I'm thinking/lost in thought, I just observe that I was thinking and then go back to the breath. Don't judge yourself for getting lost (that's just more thinking), just go back to the breath. Hope this is somewhat helpful!