I haven't done this myself to actually navigate but it was covered in a Land Nav course I took once.

You're supposed to hold wrist level in the center of your chest, 12' oclock pionts in your direction of travel directly in front of you, you then determine N/S (we used hour hand at sun and half way between teh hour hand and 12 Oclock is South in the Northern Hemisphere), once you have figured out North/South you orientate the ring to N/S. Finally as you are turning to face your direction of travel you rotate the compass ring to maintian its N/S orientation. Once you are facing teh right diection you use the watch as a reference point and rework your N/S every 10 minutes or so.

As you can guess teh error factor is pretty high.

The new compass watches like teh one you showed and Timex E-compasses have a watch hand or LCD that points North for you which makes things easier as you dial teh azmiuth you want to travel at 12' oclock, and then line up teh North hand or LCD with the North on the ring.