2) Choose the shape tool. In the options bar, make sure the tool is set for shape layers, and select a custom shape for your cut-out. Using one of the free edgy rectangle shapes from this site. The shape color doesn’t matter and the style should be set to “No style.”

3) Draw the shape in your document in the approximate location of where you want it to crop your picture.

4) Go to the layers palette and swap the order of the layers by dragging the shape layer below the picture you want to have cropped.

5) Select the picture layer in the layers palette, and choose Layer > Create Clipping Mask or Layer > Group with Previous, depending on your version of Photoshop (see note below). In Photoshop, you can choose the Clipping Mask command by right clicking on the layer in the layers palette. Or you can use the shortcut Ctrl-G in any version of Photoshop.

“In Photoshop Elements and in older versions of Photoshop,
this command is called “Group with previous.” It was renamed
to avoid confusion when the layer groups feature was added
to Photoshop.”

Both layers are independent, so you can switch to the move tool and adjust the size and position of the picture or the shape.

6) Now if you want to use the transparent image elsewhere, you will need to save it in a format that supports transparency such as PSD or PNG. You will also need to ensure that the source program supports your chosen format with transparency.
• If you want to preserve the layers for possible editing later, you should save a copy in the PSD format.
• If you wish to use the cutout in another Photoshop project, you can Select All, then Copy Merged, and paste into another document.
• If you have a later version of Photoshop (not Elements), you can select both layers, then right click in the layers palette and choose “Convert to Smart Object.” Then drag the smart object into another Photoshop document. This will keep the layers editable as a smart object, which you can double click in the layers palette to edit.

7) Areas that are transparent in the clipping mask layer will make those areas transparent in the layer above. If your clipping mask layer contains graduated transparency, then the layer above will also have graduated transparency.
To demonstrate this, go back to the shape layer we used to create the clipping mask in this tutorial. Shapes can only have hard edges, so lets convert this shape to pixels. Right click on it is the layer’s palette, and choose “Rasterize Layer” in Photoshop or “Simplify Layer” in Photoshop Elements. Then with the layer selected, go to Filter > Blur Gaussian Blur, and set the radius to a high amount such as 30 or 40. Notice the edges of your picture now fade out.
You can give the picture a bit of added punch by adding effects to the shape layer. Added a stroke and drop shadow to the shape layer, then added a pattern fill layer below everything for the background.

To Add Effects in Photoshop:
Double click in a blank area of the layers palette for the layer where you want to apply the effects. The Layer Style dialog will appear. On the left side, click on the effect you want to apply, and adjust its settings. Use the check boxes to turn each effect off or on.

http://graphicssoft.about.com/od/photoshop/ss/pictureinashape.htm