The best time to pick the lavender is when the flowers are about to come out, but really any time before the flowers die and go brown.
Take a bunch, say 20 stalks and place the heads in a paper bag (must be paper not plastic, has to be able to breathe) tie the neck of the bag with string around the stalks. leave enough string to be able to hang up the bunch to dry in the air. (I tie mine to the banisters, but you may be accused of witchcraft)
Leave to dry for about 2 - 3 weeks depending on the weather.
Shake the bunch before it goes in the bag to remove any insects. ( I have never found any insects small enough to hide in the lavender)
When the lavender is dry take a bowl, hold the lavender over the bowl and pinch off the flowers with your fingers, just run your fingers down the stalks and the flowers should come off easily now that they are dry.
If you make an inner packet, make it of a loose weave like muslin, so that the scent can come through.
How much you put in depends of course on the size of the bag, but you are right to say that they should not be stuffed too tight. The lavender will release the scent better if the flowers have room to move around.