The suburb is named after Robert Watson, who was a former harbour pilot and harbourmaster of Sydney port in 1811, and the first superintendent of the Macquarie Lighthouse in 1816. This suburb was one of the earliest to be settled, with the first land grant given in 1793 to Edward Laing; yet it remained an isolated fishing suburb until the 1860s when a small but steady influx of settlers began to arrive.

On August 20, 1857 the ship Dunbar carrying 121 passengers mistook the Gap to be the entrance to Sydney Cove and the ship was wrecked on the cliffs below. Only one person survived, and a memorial was erected in Camperdown cemetery. As a result of this horrific accident, a Hornsby Light was built on the tip of South Head.

The Signal Station was established in 1790 to inform any ships arriving from England where the colony was in case they would sail away, not knowing how to locate it. Govenor Phillip erected a flagstaff and a lookout to indicate the position of the colony. Lieutenant Daniel Southwell was then placed in charge of the lookout and remained in this job from March 1790 to March the following year.

The first signal was made on April 5 1790, but the arriving HMS Supply could only bring the bad news that HMS Sirius had been lost at Norfolk Island. In 1790 a white column was erected near to the signal station and by 1794 an iron basket with a fire to signal ships at night had been erected.

The demise of the signalling station in 1818 was caused by the construction of Macquarie Light, and by 1873 it was decided to increase the power of Macquarie Light; but at the suggestion of James Barnet, a completely new lighthouse was constructed and run solely on electric power. This construction was completed in 1883.

The fishing boats haven't landed their catches at Watsons Bay since the 1950s , yet despite this one of the most exclusive seafood restaurants, Doyles, is located in Watsons Bay.

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