A watch-only wallet shows balances and history for addresses it does not control. The capability comes from a property of key derivation that separates observing from spending.
Public keys can be derived independently
Hierarchical deterministic wallets derive child keys from a parent, and the scheme allows child public keys to be computed from the parent public key alone.
An extended public key therefore generates every receiving address in an account without any private material being present.
Spending requires a signature, which requires the private key. Deriving public keys forward does not work in reverse.
What this makes possible
A phone or desktop application can display an entire cold storage balance while the keys stay on a device that is never connected.
Receiving addresses can be generated on demand, so a business can issue fresh addresses to customers without the signing device participating at all.
Accounting systems can import an extended public key to track activity continuously, giving read access to a bookkeeper without giving spending authority.
Signing happens elsewhere
The watch-only wallet constructs an unsigned transaction, selecting inputs and setting outputs and fees, since all of that needs only public information.
The unsigned transaction is transferred to the signing device by file, camera or cable, signed there, and returned for broadcast.
This workflow is what an air-gapped setup means in practice, and the watch-only half is the component that makes it usable day to day.
The privacy tradeoff is significant
An extended public key reveals every address in the account, past and future, so anyone holding it can see the full balance and transaction history.
That is a substantial disclosure. It exposes holdings to whoever obtains the key, including any server the wallet software queries.
Wallets that query public servers leak the same information, which is why privacy-conscious setups run their own node or use techniques that obscure which addresses are being requested.
A cautionary detail about older schemes
In the standard non-hardened derivation used for watch-only accounts, combining the extended public key with any single child private key allows recovery of the parent private key.
The consequence is that leaking one child key alongside the extended public key compromises the whole account, not just that address.
This is why extended public keys should be handled as sensitive material even though they cannot sign, and why hardened derivation is used at the levels above the account.
Hardened derivation breaks the ability to compute child public keys from a parent public key, which is exactly why it cannot be used at the level a watch-only wallet needs to observe.