This term is very often heard when dealing about audio, but in fact everyone speaks about the headroom margin. The definition is utterly simple: keeping a safety zone between your signal and the clipping point.
How is this safety zone defined ?
By a good gain structure and a point of reference on your measurement tool (vu-meter, bar graph). If you set your point of reference (called alignement level) too high you will not have much headroom left before distortion. For example, with digital audio, the industry has settled for different norms which are around -20dBFS or -18dBFS, leaving 20 (or 18) dB of headroom.
Field of use
The point of reference differs depending of where we look at headroom:
and the field where headroom is considered: digital audio or analog audio.
Headroom while playing guitar
This a grey area. Guitar players like their clean tones, but at the same time a lot of them seek a touch of distortion depending of their pick attack. So headroom is hard to describe in the guitar world. It is the amount of clean level you can get before having this sweet overdriven tone appearing on each pick attack. But it is not unwanted.
Headroom while recording
You want your incoming signal to your recording device to be the most dynamic possible. If you are recording on a DAW, if you record without a safety margin you will digitally clip the sound, which renders your take useless. If we look at the preamp before the DAW, if you tend to have too much gain, your preamp will compress the signal leading to less dynamics. This where the -20 (or -18) dBFS industry standard comes in.
Headroom while mixing
Once your takes are recorded with enough headroom each, the summation of each track will bring your mix near to your maximum level allowed before clipping (if in digital) or compressing (if in analogue). A mix without headroom will lead to listening fatigue, and no scope in the music. It is the dynamics that give landscape to a song (calm verse, heavy chorus for example). Here the headroom is still important even though of much less amplitude. We will keep a very small margin of headroom (less than 5 dB), achieved with the help of compressors.
When considering headroom, moreover when recording, your gain structure will be the key to a great sound.