An example of decrypting a quadrature rotary encoder with the interrupts on an Arduino.
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README.md

Arduino-Based Quadrature-Rotary-Encoder Decryption

For the full tutorial, see the link below:
https://sites.google.com/site/hmcfabstudio/tutorials/digital-electronics/optical-rotary-encoders

Overview

Joshua Vasquez May 26-28, 2012 Rotary Encoder Example V2:

  This code uses the FULL capabilities of the Arduino's 
  hardware to effectively QUADRUPLE the resolution of the encoder.
  
  At the heart of the code is a finite state machine with
  four states.  Rises and Falls in the pulses on both channels
  govern which state to enter and when to increment or 
  decrement the index counter.  
  
  The Arduino's two dedicated interrupts can detect both rises
  and falls in a signal pulse.  For this reason, we can quadruple 
  the resolution by detecting the beginning and end of the
  individual slits on the encoder wheel (i.e: by detecting the 
  edges of the two channels from the quadrature encoder waveform.) 

  Note: The Arduino operates at 16 MHz.  Suppose the Optical
  Encoder rotated at 30,000 RPM, which is 500 rotations
  per second, or 2000 * 500 = 1,000,000 triggers of the interrupt 
  per second.
  
  My guess is that the Arduino can still handle this and still
  appear to function normally for some other rudimentary 
  application like printing data to the serial port.
  
  I assume this behavior because I am assuming that the ISR consumes
  less than 16 clock cycles to complete, and the Arduino is operating 
  at 16 [MHz].  Thus, the Arduino is ready to detect the next encoder
  interrupt within the next millionth of a second.

  Luckily, these encoders aren't meant to be run faster than 
  30,000 RPM.
  
  Nevertheless, the Arduino really can't do much more than read
  the encoder and Serially output the value. 


Optical Encoder Model:
  HEDS-9140
Encoder wheel model
  1"-500-9140-A00 REVB
  (500 CPR, counts per revolution)
Settings:
  Channels A and B are pulled up to Vcc with 2.7[kOhm] resistors.


Note the pinouts to the Encoder: they're different from before!!
Connecting Elements: 
 Encoder:            Arduino:  
  Channel A            Digital pin 2 ---> interrupt 0
  Channel B            Digital pin 3 ---> interrupt 1