How do you decide what keywords to SEO?

So you have a website or a product that you want to improve in search engine rankings. You have to pick the best keywords that people are going to search for where arriving at your page would be relevant. But some keywords are already SO heavily dominated that it's not even worth trying to take them on. So you have to find some keywords that are not so heavily saturated but still targeted and of enough traffic to be of significant value.

Have I got that right? How do you decide which is which?

try google adwords so they can suggest a nice keywords for your site and try not to choose to many competitors

use keywordspy.. and see what makes sense for your competitors.

actually the key is really trying to get as much traffic as possible

Look at the sticky threads in the White Hat SEO forum. You'll find a thread in there called "Some Links to help you out". It lists a lot of tools and websites you can use for keyword research, (as well as a lot of other useful tools for SEO).

Look at the serps and see what currently is ranking.
See if there are any exact match or closely matched domains available.
Take a guess at if you can outrank the current serps.
Estimate the traffic / profit you'd make if you were to rank at position x for the term.

You really just need need some experience, and then you'll be able to have a gut feeling if a keyword is worth your time.