The watermark image needs to be either in a gif or png format.
There is no setting in admin other then no/yes for watermarking.
Since you have watermark on the small image, you have it turned on.
What about the medium and large settings? Do you it set to "Yes" for watermarking?
What about watermark_MED image? Is it in the images/medium folder?
What the watermark_LRG image? image/large folder.
Also have you check the permissions both on the folder and image?
We know that the watermark.png small is fine so copy it the medium folder and rename to watermark_MED.png.
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