These steps are published on the Android Developers site (https://developer.android.com/training/wearables/apps/creating.html), in the Creating and Running a Wearable App section. They are repeated here and expanded upon for convenience.
To set up an Android Wear virtual device, click Tools | Android | AVD Manager in Android Studio and perform the following steps:
Click on the Create virtual device... option.
Click Wear in the Category list:
Select Android Wear Square or Android Wear Round.
Click on the Next button.
Select a release name (for example, KitKat Wear).
Click Next.
Change any preferences for your virtual device (optional).
Click Finish.
Start the emulator:
Select the virtual device you just created.
Click the green play button.
Wait until the emulator initializes and shows the Android Wear home screen.
Pair the Android handheld device with the Wearable emulator:
On your handheld device, install the Android Wear app provided by Google from Google...