In a nutshell, first person narration using an "observer" means that the narrator/viewpoint character is an observer of the protagonist, not the protagonist themselves.
Before talking about this variety of first person narration in detail, let me first go right back to the basic logic behind it...
Novels written in the first person point of view are usually narrated by the protagonist.
In The Catcher in the Rye, for example, Holden Caulfield is...
First person narration using an observer is different because the narrator/viewpoint character is not the protagonist.
So in the Sherlock Holmes novels, Holmes is the protagonist but it is Doctor Watson who is the narrator (the one telling the story after the events are over) and the viewpoint character (the one whose eyes we see through).
Other than using a character who is not the protagonist to tell the story, first person narrator "observer" novels are exactly the same as traditional first person point of view novels.
All you have to remember is that the story's focus should always be on the protagonist, not on the narrator.
The narrator will have some role in the events, other than merely observing them - they will have their own goals and encounter their own obstacles, and so on.
But their own story will nevertheless be very much a subplot to the protagonist's main plot...
The simple answer is that some stories will simply lend themselves perfectly to it. What kind of stories? Here are four circumstances under which you might consider first person narration using an observer...
As you will find out in the section on Creating Characters, all protagonists should be "larger than life" to an extent.
But go too far, or fail to counterbalance their largeness with a good dose of ordinariness, and you could end up with a central character that the reader will find difficult to warm to...
Viewed through an ordinary pair of eyes, like Doctor Watson's, Sherlock Holmes is a fascinating character.
Viewed through his own eyes, however, he would quickly become insufferable.
Put simply, Holmes is too clever, too aloof, too unfeeling, too brilliant, too everything for more ordinary people, like the readers of novels, to relate to.
Watson isn't, though - he is just like us, the kind of man we would happily share a drink with.
More to the point, he is the kind of man we would happily listen to while he told us of the exploits of his friend Sherlock Holmes. And that is the essence of first person narration using an observer.
This is related to the previous point. If a protagonist is so far removed from an ordinary person, stepping into their shoes and seeing the story unfold through their eyes can be an uncomfortable experience for readers.
Much better to view the events through a more down-to-earth pair of eyes.
But restricting the viewpoint to the "observer" has more advantages than merely making the storytelling experience more comfortable for the readers.
It actually makes the protagonist more mysterious than they could ever be if we had access to their innermost thoughts and feelings.
It is like in real life: not knowing a person gives them an air of mystery; get to know them, though, and the mystery disappears.
And sometimes with a fictional character, mystery is good.
It is an unbreakable convention, or rule, in first person novels that the narrator should always be honest with us.
So it wouldn't work, for example, to write a first person point of view novel from the viewpoint of a murderer, and for them not to tell us that they are guilty.
Of course, the information that a narrator must not withhold doesn't have to be as extreme as having blood on their hands. It could be something more mundane...
But whatever information they have, large or small, it is their duty as a first person narrator to play fair and not withhold it from the reader just so that they can spring a surprise on them later.
But what if you don't want to do this?
Then either write your novel in the third person point of view, or go for first person narration using an "observer".
In A Prayer For Owen Meany, for example, Owen Meany, the protagonist, suspects that he is the Son of God (sounds weird, I know, but it's a brilliant novel and well worth studying if you believe that using an observer as a narrator might be right for you).
This "Son of God" information isn't revealed until later in the novel, but if John Irving had made Owen Meany the novel's narrator, he would have had to make his narrator reveal it. By using an observer as a narrator - John Wheelwright, Owen's best friend - the narrator doesn't have to reveal the information because they aren't aware of it themselves.
Or look at Sherlock Holmes. Holmes, as a detective, always works out the solution to the case quite some time before Watson (and us readers) is let in on the explanation.
If Holmes narrated the stories himself, he would have to let us know his thought processes all the way through. But because we see the novel through Watson's eyes, the only clues we get about what is going on inside Holmes's head is what Watson thinks is going on inside Holmes's head - and that, of course, is usually wrong!
Simple, this one: first person narrator's can't die! If they did, they wouldn't be around to tell us the story afterwards (except, of course, if they narrate the events from beyond the grave).
So what happens if your novel's protagonist meets an unfortunate end, and therefore isn't in a position to tell the story at the end?
Again, you either write a third person point of view novel, or you use first person narration through an observer's eyes.