The optical encoder is connected to port 2 pin 2 and goes high when triggered,i was thinking maybe i should use port3 pin 2(INT0\bar) and wont have to use the timer as a counter but i fall short on how to use this external interrupt.
1) why "wont have to use the timer as a counter"
2) if using int0 just inc DATA variable
3) using T2 gives you a 16 bit count, do you need more

AGAIN:
which derivative are you using?

If the interruted does occur i need to incerment r1 so when i return from the subroutine i can display it on a 7 seg display.
For example P2.2 goes high 6 times in 5 seconds r1 will read 6 so later i can display the content R1.
never us a register for a dedicated purpose, use a variable. Sure, it will "work" if you are careful, but you set a trap for errors occurring with every change to the code.

Erik