Let me guess, when you try to select "Use your Apple Watch to unlock apps and your Mac", it reports "unable to communicate with Apple Watch" even though it is on your wrist, unlocked, and all the numerous system requirements are met. Is that correct?
For reference, please review all the steps in Unlock your Mac with your Apple Watch - Apple Support including "How to set up Auto Unlock." Then, confirm you already tried the two suggestions under "Learn More."
Specifically (emphasis added):
- In Security & Privacy preferences, deselect ”Use your Apple Watch to unlock apps and your Mac,” then restart your Mac and turn this setting back on.
- Make sure that your Mac isn't using Internet sharing or screen sharing.
If you exhaust every possible solution in that Support document and it still isn't working, I suggest you forget about it for at least 24 hours. Because that's what I did, and a day or two later it just started working again. I did nothing.
🤷🏻♂️