I'm having pretty much the same problem with watermarking.
I've uploaded my image (watermark.gif), entered the full path in 'watermarking' options selected 'yes' from the list to enable watermarks, checked ALL the user groups in the catergory I want watermarked and applied it to all of the child galleries but I still don't see any watermarks on the images.
I don't get an error message like the guy above but if I enable 'on the fly' image protection I can't view large versions of my photos, when I click on a thumbnail I'm just presented with the image title.
The gallery is here - http://mnpctechcom.temp.powweb.com/gallery
Everything in the 'Mnpctech Gallery' should have the watermark applied to it, but as you can see something isn't set correctly.
Ignore the watermarks already there that say "mnpctech.com" as those are on the raw image already, the actual watermark should say "mnpctech.com/gallery"