Watson, who rose to world number 71 after her run to the third round at Wimbledon, was broken four times in the first set, breaking back twice to lose it 6-3 as both women struggled to hold serve.
Former world number 50 Chan was surprisingly clinical, taking all four of her break points compared to Watson's two of four, the Brit herself only winning eight per cent of her second-serve points.
There were breaks galore in the second set, with Watson matching her opponent at three apiece and pushing her second-serve points ratio to 50 per cent, but she lost the tie-breaker comfortably after an early mini-break.
Watson has risen up the rankings to become British number one, her WTA placing of 71 meaning she will receive invites to Grand Slam events.
Chan, meanwhile, faces the winner of Jelena Jankovic and Melinda Czink's match later on Wednesday.