The highest resolution you can go with a simple optical quadrature encoder is around 200p/rev depending on diameter.
After that you need to use a grating to create a Moiré effect that takes the resolution up to many 1000 pulse/rev.
Max.

 

Max, I have a two track code wheel, outer track 34 mm dia. 240 slots, so slot is about .222 mm
wide.Would seem hard to do.

 

The photo etched glass type have a grating with slots numbering in the thousands. It is quite neat to see the Moiré effect in operation.
Max.

 

A 4 track Gray code wheel will give 16 positions, or 22.5 deg. / position. Are you sure that that is not fine enough ? Are you in the US ? The Electronic Goldmine has inexpensive photo reflective sensors like those in the above " Owl " project.
The control knob will need to provide a binary number for each position ?

 

I was just doing a comparison to typical 1000 line quadrature and up encoder used in motion control.
A skewed grating is used that is placed in front of the opto receiver to achieve the effect and the high resolution.
Otherwise the receiver cannot distinguish that fine a grating.
Max.