The USS Enterprise-D is ordered by Starfleet Command to take part in a combat practice simulation in preparation for the Borg threat. Both Captain Picard and Commander Riker are reluctant to participate, citing Starfleet's traditional role as an exploratory and paramilitary organization, not an actual military. Nevertheless, they follow the orders. A Zakdorn strategist named Sirma Kolrami is sent to the Enterprise-D to serve as tactical consultant and overseer of the simulation. Kolrami's severe condescension toward the crew is only made stronger when he easily beats Riker and Lieutenant Commander Data at Strategema. Data becomes convinced he is malfunctioning, but his crewmates realize he is in fact experiencing a crisis of confidence, a very human response.
The simulation consists of a battle between the Enterprise-D and an 80-year-old Federation ship called the USS Hathaway, which is in orbit around a nearby planet in the Braslota system. The crew of the Enterprise-D is split: Captain Picard, Lieutenant Commander Data, Doctor Pulaski and Counselor Troi stay on the Enterprise-D, while Commander Riker, Lieutenant Commander La Forge, Lieutenant Worf and Ensign Wesley Crusher go aboard the Hathaway. Each ship will try its best to disable the other, although for the purpose of practice, they are using simulated phasers instead of real ones.
The Hathaway, clearly technologically obsolete, is completely out of antimatter, making warp drive impossible. However, Wesley Crusher pretends to have left an experiment running on the Enterprise-D, and temporarily beams back to shut it down. He beams the experiment, containing antimatter, to the Hathaway. This allows them Warp 1 for two seconds.
As the battle begins, Riker allows Worf to use a trick he designed. The Hathaway disrupts the Enterprise-D's sensors, causing them to see a fake image of a Romulan warship that is supposedly attacking them. While the Enterprise-D turns to face the fake Romulan ship, the Hathaway scores a direct hit on them.
However, the simulation is abruptly cut short by an attack by a real foreign enemy: the Ferengi warship Kreechta under the command of DaiMon Bractor (Armin Shimerman). Believing the Kreechta's approach to be another of Worf's feints, Picard initially ignores it. However, the resulting Ferengi attack on the Enterprise-D locks the Federation ship's weapons into the harmless war-games mode, leaving it defenseless.
The Ferengi had seen two Federation ships fighting each other, noticed that the fight was hopelessly mismatched as one ship was far superior to the other, and thus deduced that the smaller, older ship must contain something very valuable. Being Ferengi, they want to have this valuable thing for themselves. The Ferengi threaten to destroy the Enterprise if it is not turned over to them.
Of course, giving in to the Ferengi's demands isn't an option because there is nothing valuable on board the Hathaway, and the Ferengi probably would not have simply withdrawn had Picard admitted to the simulation. So Picard and Riker agree to a cunning plan: The Enterprise-D fires photon torpedoes at the Hathaway, but an instant before they hit, the Hathaway goes to warp speed (thanks to Wesley Crusher's antimatter). This works, causing the Ferengi to think the Hathaway was destroyed. They then prepare to destroy the Enterprise-D, but Worf uses his sensor trick again, causing the Kreechta to see a fake Federation starship. Thinking they're outnumbered, the Ferengi escape to save their lives.
The simulation over, Data challenges Kolrami to a Strategema rematch. However, this time, he alters his strategy by playing to a draw instead of playing to win. Kolrami, frustrated at Data's apparent stalling, quits the game in disgust - to the delight of the Enterprise crew.