The 21-year-old winger, who joined the Black Cats from Altrincham in 2013, has put pen to a four-year contract which will keep him at the Wearside club until the summer of 2020.
"Duncan is an exciting prospect and the kind of talent you want to see coming through at your club," Allardyce told the club's official website.
"He is a bright young man, he has a sensible head on his shoulders and if he continues to make the kind of progress we have seen this season, I am sure that he has a great future ahead of him."
Watmore added: "I'm delighted to sign my new deal and commit my future to Sunderland.
“I've had a great few years here developing my game and now I hope to push on further, with the help of the staff, my team-mates and the supporters, who have all been fantastic with me."
#SAFC are delighted to announce that Duncan Watmore has signed a new long-term contract until summer 2020. pic.twitter.com/U7fLQ7f7Jc
— Sunderland AFC (@SunderlandAFC) November 22, 2015