Are you using the parallel port or an external controller such as the SmoothStepper?
Hood

I'm using SS, USB.

Ok encoder index will work great. I would suggest you connect it to Port3  as they are likely a bit faster seeing as they are intended for encoder input.
Hood

Assigning Pins:
A-Port # = 3
A-Pin #= 1

B-port # =3
B-pin # = 2

As for Index....

As far as I know the SS does not support full encoder input for syncing Z to spindle so there is no real benefit of connecting the A and B channels.
You do however want to connect the Z signals, if it is a differential encoder then connect Z+ and Z- to the differential pins on port 3. You then go to Ports and Pins, Inputs and scroll down to Index and enter Port3 and whatever pin you have the index connected to.
In Config, Spindle Pulleys you make sure you have your Max and Min speed  set and also set the ratio to 1 (assuming encoder is direct connection to spindle)
You should now have spindle speed readout when you command a spindle rotation (M3 or M4) The Index will also be used for lathe threading.
Hood

Thanks Hood!!



By the way I swapped the encoder to Shimpo RE2-60-C.



http://www.google.com.tw/imgres?q=shimpo+encoder,+RE2-60&um=1&sa=N&hl=en&tbm=isch&tbnid=cceWuiystzB94M:&imgrefurl=http://www.plazathai.com/show-246265.html&docid=m3UK9OMP2sKpTM&imgurl=http://www.plazathai.com/uppic/59/3ab3798a16927a44a3a5bd1ed334d559.jpg&w=800&h=600&ei=2ESwUfrNMc28kQXW8oH4Ag&zoom=1&ved=1t:3588,r:1,s:0,i:83&iact=rc&dur=488&page=1&tbnh=183&tbnw=231&start=0&ndsp=61&tx=161&ty=73&biw=1920&bih=974

This came to my mind, If M03/M04  is called it won't start the spindle Automatically because it is using a Variable speed controller connected to CN1B, If I take the CN1A step and Dir wires to SS port 1 Pin 8 & 9, what else do I need to configure in order to make it spin when M03 command is called?

What is CN1A and CN1B?
Hood

When connecting to BOB CN1A is used, if using varialble speed control mode CN1B is used:

Yes, definitely set it up as Step/Dir spindle, it will work much better with one exception. Spindle override with the SS/ESS and Step/Dir spindles is not perfect, unless it has been sorted recently, I waited for  3 years but it never got done and I have now moved on. With a light spindle you may not notice the problem as it is not nearly so noticeable on my mill as it was on the big lathe. Other than that however it works very well.

Hood