The 60-year-old Watson, coming off a win with Jack Nicklaus in the Champions Skins at Kaanapali, overcame a rocky start and finished with nine birdies and three bogeys for a 15-under 129 total.
That was two better than Fred Couples, who shot a bogey-free 66, and is making his first official Champions Tour start on a sponsor exemption to the winners-only event.
Players had a second day of mostly calm and hazy conditions at Hualalai Golf Course, with the volcanic fog from Kilauea covering the Kona Coast.
Tom Lehman had a 67 to join Michael Allen (66) at 12 under. They were a stroke ahead of Mark O’Meara (65) and Phil Blackmar (67).
After momentarily giving away the lead when he missed three very short par putts on the front nine, Watson surged back to the top with five straight birdies to start the back nine to reach 14 under and open up a three-stroke lead.
The eight-time major winner got the birdiefest going by two-putting for birdie on the par-5 No. 10. He followed with birdie putts from 8, 15 and 12 feet, and added a tap-in for birdie on 14 after a near-perfect 8-iron shot.
The last time he had five birdies in a row was the first round of the 2008 Outback Steakhouse Pro-Am, where he went on to win.
After parring 15, Watson hit an 8-iron to 12 feet for his final birdie.
Watson is seeking his first win since teaming with Andy North to take the 2008 Liberty Mutual Legends of Golf. Watson was winless last year, but finished second at the British Open.
Watson, who was bogey free on Friday, struggled with his putter early. He started with a three-putt from 18 on No. 1 where he missed a 3-footer for par. He then missed a gimme on par-3 eighth and a 4-foot putt for par on the next hole, which dropped him a stroke off the lead.
Just as it appeared Watson would self-destruct on the greens, he regained control of his putting and the lead.
Couples, who turned 50 in October, used his length to his advantage. The 1992 Masters champion was steady all day, but his best shot came on a spectacular par save from the bunker on No. 11.
After his second shot skipped across the green and rolled into the bunker, Couples chunked his sand shot, which bounced off the grass and rolled back to within a couple feet of Couples’ shoes.
He then holed his second bunker shot to save par and a share of the lead at 10 under, drawing a wide grin from Couples.
He closed the round with birdies on Nos. 16 and 17.
Lehman took the outright lead at 10 under by birdieing the par-3 fifth, a hole he triple bogeyed on Friday. Watson took the lead right back with tap-in birdies on the next two holes. He nearly holed it from the bunker on the par-5 seventh, with his ball hitting the pin.
Lehman started the day with a birdie, hitting a wedge from about 80 yards to 3 inches of the cup. But he couldn’t make a move after his birdie on No. 5 with 10 straight pars.
The 74-year-old Gary Player shot his age and for the 29th time in his storied career, but was in last place at 6 over. Player got the birdie he needed to reach his age by holing a bunker shot for birdie on 16.